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					     MONETARY POLICY   277




             Part III


Macroeconomy
                                                                                         MONETARY POLICY      279




                                        Monetary Policy
                                           Dr. Yuba Raj Khatiwada
                                    Executive Director, Office of the Governor
Structure of the Nepalese                                                     There was a small change in the
Economy and the Role of                                                 structure of the economy till 1980s. The
Monetary Policy                                                         Multipurpose Household Sur vey of
                                                                        Nepal Rastra Bank (NRB, 1989) showed
    Evolution of monetary policy of                                     58 per cent of the household income in
Nepal took place at a time when monetary                                kind, 57 per cent of the rural
deepening was very low, when there were                                 consumption on home produced goods
only a few financial institutions, and when                             and ser vices, 84 per cent of the
the degree of monetizations was very low.                               consumption expenditure was on
The economy was mostly of subsistence                                   domestic goods and services in 1984/85.
nature with agriculture contributing more                   The monetary deepening was still low with broad
than 90 per cent of the economic activities. Till mid       money supply/GDP ratio remaining at 28 per cent.
1960s, narrow money to Gross Domestic Product               The comparable figures for India and Sri Lanka at
(GDP) ratio was 8 per cent only and broad money             that time were 43 per cent and 31 per cent
to GDP ratio was less than 10 per cent compared             respectively. However, the process of monetization
with 20 per cent in India and 23 per cent in Sri Lanka.     speeded up in the 1980s by virtue of aggressive bank
Financialization of assets was very low even till the       branch expansion and massive injection of money
end of 1960s. Agricultural Credit Survey done in            through the fiscal deficit. The outward orientation
1969/70 revealed financial assets of the households         of the economy also played a key role in this process.
comprising not more than 4 per cent with land                   Stage of monetization has a significant bearing
building and livestock comprising more than 90 per          on the conduct of monetary policy. First, income
cent of the household assets (NRB, 1972). In 1969/          elasticity of money demand tends to be high in an
70, only 38 per cent of the households were borrower        economy which is monetizing; hence, monetary
of one kind or the other. Of the borrowers, more            targeting without due consideration to this process
than 42 per cent borrowed in kind. Of the total             can suppress economic activities. Second, the scope
borrowing amount, 24 per cent was in kind. Nearly           of monetary policy is defined by the stage of
78 per cent of the household expenditure used to            monetization and success of the objectives of
go on food consumption; another 6 per cent was
                                                            monetary policy to attain higher output and
spent on clothing and footwear; thus leaving only 16
per cent of the expenditure on other consumption.           employment, if any, is contingent upon this. Third,
The share of institutional credit in total borrowing        monetary policy itself has a role to speed up
was 18 per cent only of which the share of formal           monetization and financialization of savings so that
financial institutions was one third (6 per cent).          allocative efficiency of limited resources could be
280   NEPAL RASTRA BANK IN FIFTY YEARS

maximized through the process of formal financial       Evolution of Nepal’s Monetary and Credit
intermediation. As the process of monetization          Policies
speeded up in the 1980s and 1990s along with                Nepal Rastra Bank began exercising monetary
deepening of the financial system, a wider room for     policy since mid 1960 with instruments like credit
monetary policy operation could be created by that      control regulations, interest rate administration,
time.                                                   margin rates, refinance rate, and cash reserve ratio.
    External trade, foreign exchange openness, and      In the 1970s, liquidity requirements, credit limits /
exchange rate regime also shape the course of           ceilings and directed credit programmes were
monetary policy. Nepal started looking outwards         introduced. Open market operations evolved only
in terms of economic relations right since the          in the 1990s with policy shift from direct to indirect
1950s, and evolution of external trade and foreign      monetary control. Effective exercise of cash reserve
exchange regimes began in the 1960s. However,           requirement and bank rate as active monetary policy
trade-GDP ratio was less than 15 percent till 1970.     tools evolved even later—since late 1990s. The basic
Both trade and foreign remained controlled till         objectives of monetary and credit policies have been
early 1990 and exchange rate remained fixed until       fostering growth, generating employment, addressing
mid 1980s when a more flexible currency basket          poverty, containing prices, promoting external trade
system of exchange rate deter mination was              and attaining healthy balance of payments of the
introduced. But Nepal could never evolve to a           country. As so many objectives had been assigned to
fully flexible exchange rate regime from fixed          monetary and credit policies, it was hard to attain all
exchange rate system against Indian rupee. Neither      of them, many of them conflicting to each other.
there was much room for divergence in                   Also the distinction between monetary and credit
macroeconomic policies the country could adopt          policies remained blurred and assessment of the
from those of India. Open border, trade                 impact of monetary policy became difficult. Recent
concentration, fixed exchange rate regime, and free     shift of the monetary policy objectives from growth
and unlimited convertibility of currency still          focus to stability has to some extent enhanced its
continue to shape the course of Ne pal’s                credibility. But still the hangover of setting multiplicity
macroeconomic policies; and this also limits the        of objectives is there in the policy-making institutions.
exercise of independent monetary policy even
today.                                                  Monetary and Credit Policies: a Distinction
    There have been noteworthy structural shifts in         Often monetary and credit policies are interpreted
the Nepalese economy—composition of GDP has             in the same way. Nepal Rastra Bank has also been
changed from more than 90 per cent share of             exercising monetary and credit policies through the
agriculture in 1960s to less than 40 per cent now,      same banner. But monetary and credit policies are
trade-GDP ratio has exceeded 40 per cent, foreign       not exactly the same. Monetary policy is defined as a
exchange regime has been liberalized, and much          policy affecting changes in the quantity of money
monetary and financial deepening have taken place       while credit policy is defined as a policy affecting the
with broad money-GDP ratio at more than 56 per          cost, availability, and the allocation of credit. Money
cent in 2004. But some fundamentals in the exercise     differs from credit because (i) money is the liability
of monetary policy have not yet changed from the        of the banking system whereas credit is an asset, (ii)
establishment of NRB in 1956 to date. Nor have          money refers to banking system only whereas credit
the relationships between macroeconomic variables       has a wider coverage; it consists of lending of all the
like prices, interest rate and exchange rate diverged   banks and non-banking institutions, and (iii) money
significantly. So long as Nepal continues to have       is the most liquid form of assets whereas credit is
current trade, payments, and foreign exchange regime    not. But money is created in the process of credit
with India, there is not much maneuverability in the    creation and therefore they are two facets of the
country’s monetary policy as well. Structural changes   same coin.
in the economy seem to demand shift in                      The authorities have to make a choice between
macroeconomic policies as well; but, as the following   monetary and credit policies. One reason why
sections will reveal, the room for such policy shift    monetary policy is preferred over credit policy as a
remains fairly limited.                                 macroeconomic policy variable is the underlying
                                                                                            MONETARY POLICY      281

theoretical developments. There is no specific theory         of the banking system and hence money supply.
of credit demand as the theory of demand for                  When control of money or credit supply is the need,
money. The theory of demand for money regards                 interest rate structure may be revised upward. If the
real income or output, interest rate and inflation as         central bank has no direct control over the interest
the major factors affecting the demand for money.             rate structure of the commercial banks, the same
These may be taken also the factors affecting demand          can be done indirectly through open market
for credit, but with a point of caution. Demand for           operations and changes in the bank rate. But control
money is for transaction and asset purpose whereas            of money supply or credit through interest rate is
demand for credit is for investment or consumption            possible only if market interest rate is sensitive to
purpose. However, as the determinants of demand               bank rate and if market borrowing is also sensitive
for money seem to closely affect demand for credit            to bank lending rates.
as well, we may regard business expectation or                    The situation in Nepal is something different; it
desired output growth, interest rate, and inflation rate      has past instances of higher credit growth
as the factors affecting demand for credit. This in           accompanied by high interest rate structure. This has
fact works as a monetary reaction function where              happened owing to the administered interest rate
not only money supply determines inflation, but prices        structure for quite a long time coupled with
also affect the demand for working capital and thus           underdeveloped bond market and substitution of
determine the supply of money through the process             money to physical assets rather than to bonds taking
of credit (and demand deposit) creation. When prices          place. The latter is quite common in an inflationary
are rising, there is a higher need for working capital;       situation when the real value of financial instruments
as an entrepreneur has to make a higher payment for           depreciates and the value of physical assets
raw materials, labour, and machinery.                         appreciates. Besides, empirical studies on the
    Recent researchers have identified credit as an           relationship between private sector borrowing from
additional channel of transmission for monetary               the commercial banks and the lending rates of the
policy with two implications that are of particular           banks reveal no significant negative relationship
relevance for policymakers. First, it is argued that if       between the two. As the real cost of capital seems
one considers the impact of monetary policy on the            to be higher than the lending rates of the commercial
ability of the banking system to lend, credit succeeds        banks (as is reflected in the higher interest rate
as an inter mediate variable where monetary                   structure in the informal market), availability of bank
aggregates fail, specifically, when demand for money          credit is observed to be more significant than the
is unstable. In a transforming economy, policymakers          cost to determine the flow of bank credit to the
may get a clearer picture of inflation or longer-term         private sector of the economy.
economic growth by observing credit rather than                   In essence, although credit seems to be a plausible
monetary aggregates. Second, identifying the credit           variable that the central bank can exercise to affect
channel of monetary transmission has permitted a              the real economy, a stable money demand function
greater understanding of the nature and characteristics       followed by strong association between money and
of business cycles. It is argued that shocks to bank          balance of payments and to some extent a positive
credit itself may have a considerable impact on               link between money supply growth and the rate of
economic activity. As such, the credit channel is             inflation indicate that Nepal Rastra Bank is better
observed to amplify a mechanism whereby                       placed to choose money over credit as a tool to
difficulties in the real sector lead to tightness in credit   stabilize the economy and ensure adequate liquidity
markets, thus shrinking the credit available for              to promote economic growth.
investment, which in turn exacerbates the real sector’s
                                                              Interest Rate as a Monetary Policy Variable
downturn (see Khan, 2003).
                                                                  Interest is paid for the sacrifice made by the
    However, in a situation where there is no strong
                                                              income holder by deferring consumption for the time
linkage between credit demand and interest rate, it is
                                                              being and imparting with liquidity, and to reward
difficult to take credit as a policy variable. As an          the income holder for making saving. There exists a
instrument of monetary policy, interest rate can be           wide array of interest rates in the economy. This is
used for encouraging or discouraging credit flows             either because of wider verities of securities having
282    NEPAL RASTRA BANK IN FIFTY YEARS

different liquidity, term structure, and degree of risk       place in 1989 only whereby the commercial banks
or market imperfection. The main monetary policy              were set free to determine the deposit and lending
variables at the disposal of the monetary authority           rates. However, the existing number of commercial
for achieving policy goals like growth and stability          banks and the level of competitiveness in the financial
are the quantity of money, bank credit, and interest          market have not allowed interest rate structure to
rates. Keynesian economists prefer interest rate as the       evolve through a perfect market mechanism. Further,
proper monetary policy variable whereas Monetarists           there is a great deal of difference in the level of interest
opt for money supply as the appropriate policy                rates on loans between the formal and informal
variable. Many others, from neo Keynesians and                markets. Informal market rates for borrowing are
Radcliffe economists to open economy monetarists,             much higher than the formal market rates which
advocate for credit as the appropriate policy variable.       signal that availability rather than cost of credit is the
Although the supply of money and interest rate are            major determinant of credit supply in the economy.
interlinked, the central bank cannot determine both                One noteworthy situation of the Nepalese
of them and hence has to choose one of them as a              financial system has been the poor sensitivity of
monetary policy variable.                                     commercial banks to changes in bank rate by the
    In the Nepalese context, money supply is                  Nepal Rastra Bank. The direct channel of the effect
supposed to be the superior policy variable than              of changes in bank rate on market interest rate is the
interest rate on several counts. First, various empirical     increased cost of borrowing (from the central bank)
studies have shown that money supply is closely               of the commercial banks which compels the banks
related with policy goals like money income, prices,          to increase their lending rates as well. But in a situation
and balance of payments than interest rate is. Second,        when banks are themselves over liquid and do not
though money supply is an endogenous variable,                resort to central bank borrowing for financing their
affected by policy autonomous factors also, the effects       lending activities, revision of bank rate by the Nepal
of policy induced factors on it are more dominating           Rastra Bank makes no difference and commercial
and thus more prone to manipulation than interest             bank lending rates do not necessarily change. This is
rate. In the recent years, interest rates are liberalized     the reason why bank rate has not yet evolved as a
and the Nepal Rastra Bank has no direct control over          potent tool of credit control or monetary
them. And, indirect policy tools such as bank rate or         management in Nepal.
discount rate or refinance rate cannot effectively work            To achieve a higher economic growth, there has
as a tool for attaining the desired level of market           to be an increased investment both from the public
interest rate. This is because financial market is still      and the private sector. Increased investment can take
narrow, shallow and fragmented; and inter-financial           place only when savings are mobilized sufficiently.
institutional flow of fund is very limited.                   Savings, especially financial can be increased if real
    Interest rate is one of the monetary policy variables     deposit rates are positive. In this respect, Nepal Rastra
along with money supply and credit. But unlike                Bank had adopted interest rate policy for the (i)
money supply, it is difficult to adopt it as a policy         mobilization of higher level of savings in the form
variable for a number of reasons. First, there is a           of bank deposits, (ii) prevention of capital flight to
wide range of interest rates, and it is difficult to select   India, (iii) allocation of resources to productive
‘the interest rate’ which can work as a policy variable.      sectors of the economy, and (iv) promotion of
Second, it is hard to establish an effective relationship     economic activities particularly industry and trade.
between interest rate and monetary policy objectives          For those purposes, interest rates were regulated since
in a financially underdeveloped economy. And third,           1967 to 1989. In the past, when interest rates were
central bank often loses command over interest rate           controlled, Nepal Rastra Bank (NRB) attempted to
if it is deregulated in a liberal monetary policy             keep real deposit rates positive by making frequent
framework.                                                    upward revisions in nominal rates whenever inflation
    In a process to liberalize the financial system,          rates were changing. But it was not possible to do so
initiatives to deregulate interest rate structure in Nepal    all the time for the NRB. As a result, there could be
were taken since mid 1980’s. The complete                     lags and delays in the policy changes. Moreover, it
liberalization of interest rate structure, however, took      was not possible for the NRB to determine the
                                                                                            MONETARY POLICY      283

desired nominal interest rates. In this regard, market       adversely in the long run. Henceforth, the focus of
force was considered as the best judge.                      monetary policy has been shifted to the maintenance
    Interest rate spreads indicate the level of financial    of the domestic value of money. The successful
intermediation cost. The higher the interest rate            operation and conduct of monetary policy by the
spread, the higher is the financial intermediation cost.     central bank in terms of achievements of its policy
Persistent higher intermediation cost causes financial       objective is, however, closely associated with the
disinter mediation. Obviously, if financial                  degree of independence the central bank obtains
disintermediation starts as a result of higher interest      from the government.
rate spread, it inhibits the financial development.               Generally, the following arguments are put
Therefore, the liberalisation of the whole interest rate     forward for the central bank independence. First,
structure was directed at fostering competition              Central bank independence is needed to prevent time
among the financial institutions. Consequently, it was       inconsistency in the conduct of monetary policy.
thought that competition would bring down the                Second, time inconsistency in monetary policy gives
interest rate spread. However, as there was no such          rise to the problem of credibility. Once the public
achievement, the spread had to be administered in            perceives that central banks’ monetary policy actions
the later 1990s, initially at 6 per cent and later on at 5   are not credible, whatsoever good intentioned
per cent. Then the financial system had to wait for          monetary policy may be, it becomes less effective.
many years before some visible achievement in the            Third, the problem of credibility of central bank’s
reduction of interest rate spread could be observed.         policy arises when the central bank is not independent
Observing the positive trend, the maximum spread             and is forced to meet government’s request for
limit was withdrawn in 2003. But a number of                 unlimited funds. Fourth, coordination of monetary
factors still hold the spread at a higher level. They        policy with other policies especially exchange rate
include (i) segmentation of financial markets, (ii) high     policy is also needed to make monetary policy
non-performing loans and lenders’ temptation for             effective. And fifth, monetary policies conducted
high risk premium (iii) inefficiency of the large            without fixing accountability will not be effective.
commercial banks and development banks under                 Central banks can be held accountable for their
state equity capital. Concerns of the central bank over      actions and policy mistakes only when they are
high interest spread needs to be addressed through           granted independence (Khatiwada, 2000).
market related instruments and financial policies.                We normally talk of three dimensions of central
There is not much scope for exercising interest rate         bank independence, (i) political independence (ii)
as an independent monetary policy tool at this stage         macroeconomic independence and (iii)
of the financial reform.                                     microeconomic independence. Political independence
                                                             relates to having a clear objective of monetary policy.
Role of Autonomy in the Conduct of
                                                             Now, the focus is towards having a single objective
Monetary Policy                                              i.e. achieving domestic price stability. Macroeconomic
    Central bank is the apex financial institution           independence relates to freedom to formulate
assigned the task of designing and operating                 monetary and exchange rate policy. Microeconomic
monetary policy, regulating / supervising the financial      independence relates to financial independence. This
system, and ensuring a healthy growth of the                 is meant for achieving financial stability. The existence
payments system in the country. Among the variables          of a sound banking financial institutions is possible
of goal function of monetary policy, the policy focus        only when proper prudential norms are put in place
has changed over time. It is a well-known fact that          and the central bank has the power to seek the
monetary policy can be used to raise real GDP                effective compliance of such norms.
temporarily above potential level in the short run.               When NRB came into existence in 1956, the
Generally, the expansionary monetary policy may not          preamble of NRB Act, 1955 stated the objectives
generate inflation in the short run but helps reduce         of its establishment as (i) to insure proper
unemployment. However, in the long run, monetary             management for the issue and circulation of Nepalese
policy determines the rate of inflation. Inflation           currency throughout the kingdom, (ii) to stabilize the
affects productivity and the growth of potential GDP         exchange rates of Nepalese currency in order to
284    NEPAL RASTRA BANK IN FIFTY YEARS

ensure convenience and economic interests of the          are not; for example, the objective of price stability
general public, (iii) to mobilize capital for             often conflicts with the objectives of interest rate
development and encourage trade and industry in           stability and high short-run employment. Countries
the kingdom and (iv) to develop the banking system        may assign these objectives equal weights or, as many
in Nepal. The NRB Act, 1995 stated that NRB will          countries have done in recent years, place greater
have to advance loans repayable within eight months       emphasis on the objective of low inflation. This recent
in case His Majesty’s Government so needs on terms        shift has been triggered by strong empirical evidence
mutually agreed upon by His Majesty government            that high inflation (and its associated high variability)
and the Bank. The Act did not set the limit on            distorts the decision-making of private agents with
government borrowings from the NRB. Of late, a            regards to investment, savings, and production, and
‘Gentlemen Agreement’ was done not to borrow in           ultimately leads to slower economic growth. The
excess of certain amount. However, the government         liberalization of exchange rate regime, capital account
seldom adhered to this limit. NRB’s policies on           liberalization, and growing trade openness have made
exchange rate were also often guided by the               many countries to shift monetary policy objectives
government directives. Lack of independent of NRB         from domestic to external sector stability while some
from the government in this respect also impinged         others have opted for inflation targeting as a single
upon NRB’s maneuverability in the conduct of              most objective.
monetary policy.
                                                          Monetary Policy Goals for Nepal
    The new Nepal Rastra Bank Act, 2002 has been
                                                             Price and external sector stability (exchange rate/
instrumental to ensure autonomy and correct the
                                                          balance of payments) are probably the most
anomalies inherent in the NRB Act. There are now
                                                          important goals of monetary policy in Nepal. Excess
statutory limits to central bank borrowing, freedom
                                                          money supply causes an upward pressure in the level
for the fixation and management of exchange rate
                                                          of prices by increasing aggregate demand in the
and managing the financial system. But one single
                                                          economy in the wake of inelastic supply of output.
statutory objective for monetary policy could not be
                                                          So monetary policy purports to contain prices by
fixed in the legislation for obvious reasons. Nepal is
                                                          not allowing money to increase in excess of the
a small open economy with open border with India.
                                                          desired demand for it. However, the control of
Empirical studies have shown that Indian prices have
                                                          money over inflation would be contingent upon the
greater influences on Nepalese prices. This implies
                                                          share of non-tradable goods and services in the
that the central bank could not be assigned domestic
                                                          consumer basket and the degree of demand side
price stability as the sole objective. An exchange rate
                                                          pressure on prices. As about one-third of the items
regime of the present type in a capital controlled
                                                          under consumers’ price index in Nepal are non
regime did not fully support exchange rate targeting.
                                                          tradable, and as excess demand is often a cause for
And, achieving a higher economic growth rate could
                                                          price rise, targeting inflation as monetary policy
not also be the objective of monetary policy because
                                                          objective is not irrelevant. Regarding balance of
of weak relationship of monetary variables with real
                                                          payments stabilization, it is observed that in an open
GDP. As the economy evolves and makes structural
                                                          economy, excessive monetary liquidity leads to higher
shift, the central bank has to gradually move towards
                                                          aggregate demand and if the demand cannot be met
single monetary policy objective—price or external
                                                          by domestic supply of goods and services, imports
sector stability depending on what money can better
                                                          from abroad would increase. This would cause
affect.
                                                          deterioration in the balance of payments of the
Transmission Mechanism of Monetary                        country. Proper monetary planning prevents the
Policy                                                    economy from such a situation. Price stability can
    Monetary policy objectives have traditionally         also be instrumental for a healthy balance of
included promoting growth, achieving full                 payments because stable prices not only help
employment, smoothing the business cycle,                 maintaining export competitiveness of the country
preventing financial crises, and stabilizing long-term    but also encourage foreign capital inflow in the
interest rates and the real exchange rate. Although       country, both of which contribute to healthy balance
some objectives are consistent with each other, others    of payments position. With the liberalization of the
                                                                                           MONETARY POLICY      285

external sector and introduction of a more flexible        money supply is. Thus money is to be preferred over
exchange rate system, the objective of monetary            credit as the policy variable. But whether M1 or M2
policy is also to ensure a stable exchange rate of the     should be the policy variable is an empirical issue.
domestic currency.                                         The following sections will explore whether M1 or
                                                           M2 is an appropriate variable to affect the objective
Monetary Policy Variable(s) and Instruments
                                                           of monetary policy.
    The main monetary policy variables at the disposal
                                                               Monetary policy instruments in general can be
of the monetary authority for achieving ultimate
                                                           listed as bank rate (BR), open market operation
targets are the quantity of money, bank credit, and
                                                           (OMO), cash reserve requirement (CRR), statutory
interest rates. Broadly, two schools of thought prevail
                                                           liquidity requirement (SLR), administered interest rate,
on the choice of appropriate policy variable.
                                                           credit ceiling, margin rate, and moral suasions. In a
Keynesian economists prefer interest rate as the
                                                           liberal financial system, only the indirect means of
proper monetary policy variable whereas quantity
                                                           monetary control like OMO, CRR and BR are
theorists opt for money as the appropriate policy
                                                           exercised. That is what Nepal has been doing for the
variable. Many others from neo Keynesians and
                                                           last one decade and a half. In advanced economies,
Radcliff economists to open economy monetarists
                                                           bank rate can be used as an indicator of short term
advocate for credit as the proper policy variable;
                                                           (money market) interest rate. If the central bank
although the definition of credit and the objective
                                                           desires for a tighter monetary situation, it raises the
assigned to this variable are different. In the Nepalese
                                                           bank (discount) rate, which discourages commercial
context, money supply is supposed to be the superior
                                                           banks’ borrowing from the central bank and thus
policy variable than interest rate on several counts.
                                                           retards credit expansion activities of commercial
First, various empirical studies have shown that
                                                           banks. Open market operation, which means the sale
money supply is closely related with policy goals like
                                                           and purchase of securities to and from the open
money income, prices, and balance of payments than
                                                           market, is also used for attaining desired level of the
interest rate is. Second, though money supply is an
                                                           quantity of money in the economy. In Nepal, the
endogenous variable, affected by policy autonomous
                                                           indirect policy tools are evolving but their effectiveness
factors also, the effects of policy induced factors on
                                                           in controlling monetary aggregates for economic
it are more dominating and thus more prone to
                                                           stability has been mixed; as in many years of the 1990s,
manipulation than interest rate. In the recent years,
                                                           actual money supply exceeded the desired level (see
interest rates are liberalized and the NRB has no direct
                                                           Khatiwada, 1999). Nepal has had a long transition
control over them; and, indirect policy tools such as
                                                           of full evolution from direct to indirect monetary
bank rate or discount rate cannot work as the signal
                                                           policy tools, with painful instances of disfunctioning
for a desired level of market interest rate in the wake
                                                           monetary policy at times.
of underdeveloped financial markets, particularly
when financial layering ratio is very low or               The Transmission Mechanism
nonexistent.                                                   One of the highly debated issues in monetary
    An alternative to quantity of money as a policy        theory is the role of monetary policy in the economy.
variable is bank credit. It is argued that in an open      Recent theoretical as well as empirical evidence has
economy with a fixed exchange rate regime, balance         led to a widespread understanding that changes in
of payments becomes an additional source of money          the quantity of money affect income, output, prices,
supply. Under such situation, the monetary authority       interest rates, and the balance of payments. But the
can control only the domestic component of the             controversy still persisting is: what are the channels
money stock (net domestic credit). Given this, money       through which monetary impulses are transmitted
supply cannot be characterized as an independent           to the real sector? Keynesians and Monetarists both
policy variable and domestic credit, which is              acknowledge that changes in money stock have some
independent of policy goals, should be regarded as         permanent effect on output or on prices or on
the policy variable. However, as discussed earlier,        interest rate or on a combination of these. However,
there is no well-developed theory of the supply of         Keynesians emphasize the effect on interest rate and/
credit effect on economic activities, particularly on      or on output, whereas Monetarists emphasize the
income and price, as the theory of the effect of           effect on the level of prices. Open-Economy-
286    NEPAL RASTRA BANK IN FIFTY YEARS

Monetarists, however, give an emphasis on the                  suffers from disguised unemployment) to industrial
balance of payment or exchange rate (depending on              sector which generally requires semi skilled or skilled
whether a country’s currency is under a peg or float)          labour force.
implication of the monetary expansion. Keynesians                  (iii) Even if surplus labour from agriculture is made
view interest as equilibrating the demand for and              available to industrial sector, the basic problem of
supply of money, while Monetarists envision price              industries that is the scarcity of capital remains
level as equilibrating them. The Rational Expectation          unsolved and hence additional demand generated
Monetarists, however, argue that money does not                from the monetary sector will not be translated into
exert any effect on output even in the short run if            increased output and employment. When supply of
the increase in money is already anticipated. In their         output is insensitive to its demand (or the prices), the
view, only un-anticipated monetary expansion will              additional demand generated by the monetary
have any effect on real output even in the short run.          expansion is likely to impinge upon prices for non
    To recapitulate, the channels of monetary                  tradable goods and services and upon the balance
transmission mechanism, although somewhat                      of payments through higher level of imports.
concealed in the theoretical discussion, are identified            Considering the interest rate channel in the
as: (i) cost of capital (interest rate) channel, (ii) wealth   Nepalese context, it is to be noted that interest rates
effect channel, (iii) credit availability channel, and (iv)    in the organized financial market often fail to reflect
quantity of money channel. The first three channels            the true cost or availability of capital in the economy;
are very close to the Keynesian thought whereas the            there is no proper term structure of interest rates
last channel is the favourite of the Monetarists.              consistent with liquidity and maturity of financial
Exchange rate is now considered as one of the new              instruments; and, bonds market is at a primitive stage
channels of monetary policy to affect prices and               with bonds issued at face values and earning fixed
output in the economy (Khan 2003). Application of              interest income. Linkage between short term and
either of these channels in an economy hinges on the           long-term interest rates is either weak or lag in the
structure of the economy and the stage of financial            linkage is very long. Portfolio substitution mostly
development.                                                   takes place not between money and bonds but
    Relating quantity theory approach to the Nepalese          between money and physical assets. In such a
economy, it can be argued that real income in Nepal            situation, we can neither establish a positive
is mainly supply determined independently of                   association between money supply and bond prices
demand conditions and changes in the quantity of               and hence negative association between money supply
money in such a situation is supposed to impinge on            and interest rate nor choose an interest rate that
the level of prices and the balance of payments. Since         reflects the true opportunity cost of capital. As
the characteristics of the Nepalese economy indicate           interest rates can not be pegged by indirect monetary
that the economy is neither a completely closed nor            policy measures, and as so called market determined
a completely open one, the effect of monetary                  rates are often far away from the realistic level that
changes is supposed to be distributed between price            market forces should determine, the effect of changes
and balance of payments changes in the long run                in money supply on the level of investment through
with little or no effect on real output. The reasons           reduction in the rate of interest and then on real
why real income is supposed to be mainly supply                income can not be empirically analyzed. In a capital
determined can be mentioned as follows.                        constrained economy like that of Nepal, where
    (i) The economy is dominated by activities in the          informal market rates of interest are substantially
agricultural sector mostly governed by weather                 higher than those in the formal sector and where
conditions, and agricultural production which                  formal financial sector can fulfill only a small portion
constitutes about two fifth of the GDP is less elastic         of the overall credit demand, availability rather than
with respect to prices, as it is in many less developed        cost of capital is the determinant of investment
countries.                                                     demand. As such only 15 per cent of the borrowing
    (ii) Though there are a few consumer goods                 households in Nepal have resorted to bank loan; the
industries, we cannot expect an automatic transfer             rest still opt for informal sources. Transaction and
of unskilled excess labour from agriculture (which             other hidden costs in formal sector borrowing
                                                                                           MONETARY POLICY      287

undermine interest cost. So, interest rate revision of      are forced to ration the available supply of credit by
even a fairly large degree is not likely to pose any        various non price terms. The rationing of credit on
remarkable change in investment decisions. The latter       non price terms, such as default risk or credit rating
is likely to be more affected by business environment       of the customers, causes a reduction in the
- mainly the market prospect and government                 expenditure of small and risky firms or individuals
economic policies - and improvement in the financial        (as large and established firms are supposed to be
service delivery of the banks.                              less susceptible to such credit restraint); and such
     Neo Keynesians have emphasized the role of net         rationing occurs in the wake of growing demand
private wealth along with income as a factor affecting      for credit even though the rate of interest is
real flows of expenditure. If consumers are assumed         unchanged. If trade credit is not available and other
to hold bonds as well as other assets in their wealth       financial markets are absent, a limited availability or
portfolio, changes in the value of bonds brought            rationing of loan would directly be transmitted to
about by changes in the monetary sector will affect         the real sector in the form of reduced expenditure
the net worth of the consumers. But, whether it is          by business firms and individuals. One manifestation
only the rate of interest or also other monetary            of the credit flow suppression of the banks at present
variables that have wealth effect is highly debated.        is excess liquidity existing in the commercial banking
This is connected with the treatment of financial           system amidst demand for credit from the non-bank
assets (including money) as a part of net worth of          financial institutions and informal sector at a much
the public. Anyway, increase in private wealth due          higher interest rate. In essence, interest rate in formal
to changes in the prices of financial assets may            financial sector in Nepal is yet to evolve as a flexible,
stimulate consumption along with strengthening the          market representative, and true instrument reflecting
impact on economic activity of portfolio adjustment.        the cost of capital.
     In Nepal, financial assets, the values of which
                                                            Inflation Targeting — is the Condition Ripe?
change due to monetary development, constitute a
                                                                Implementation of an inflation-targeting regime
negligible portion of the net worth of the private
                                                            requires enabling macroeconomic, institutional and
sector. Whatever financial savings are held, they are
                                                            operational conditions. First, the authorities should
mainly in the form of currency, bank deposits and
                                                            be fully committed to price stability as the primary
contractual savings. Not only is the holding of
                                                            goal of monetary policy, ruling out the possibility of
equities, shares and bonds as a part of net worth
                                                            targeting any other variable like nominal exchange
negligible but also the market values of these securities
                                                            rate or interest rate or output. However, it is argued
do not change considerably owing to the absence
                                                            that exchange rate arrangements with limited flexibility
of secondary market of these securities. Interest
                                                            could coexist with inflation targeting as long as the
income on bank deposits does not constitute as a
                                                            latter has priority. Besides, in a flexible exchange rate
sizable part of aggregate private sector income, which
                                                            regime, central bank intervention in support of the
is evident from the small share of interest earning
                                                            exchange rate has to be limited to smoothen the
deposits on the GDP. Besides, return on financial
                                                            effects of temporary shocks on inflation. This is
assets including that from renting out properties
                                                            particularly important in small open economies
comprise only 4 per cent of the household income,
                                                            where the pass-through from exchange rate to
as revealed in the recent living standard survey (CBS,
                                                            inflation might be high and with short lags. Further
2004). This indicates that wealth effect working
                                                            in a strict inflation targeting regime, monetary policy
through changes in interest rate is not very
                                                            instrument may respond to the output gap, but only
instrumental in affecting aggregate expenditure.
                                                            to the extent that it affects the inflation forecast, and
     The credit availability channel is likely to be the
                                                            not because it enters in the central bank’s loss function
most direct and powerful channel of transmission,
                                                            (Khan 2003). A strict inflation targeting is difficult in
in the Keynesian setting, of monetary impulses to           Nepal at this stage when Nepalese economy is fully
the real sector in a less developed country like Nepal.     open towards India with Nepalese rupee (NRe)
This is because there exists an almost insatiable           pegged to Indian Rupee (IRe) and chances of capital
demand for credit at the prevailing interest rates in       flow across the border remaining high. In a situation
the formal financial sector, and financial institutions     when the peg has to be defended at a certain level,
288    NEPAL RASTRA BANK IN FIFTY YEARS

interventions in the foreign exchange market becomes                       gpa = bo + b1 gma1 or gma2
a regular phenomenon to correct cross rate                        Where gpa = annual inflation rate, gma1 = annual
differences in the NRe- IRe and US dollar exchange            growth of narrow money and gma 2 = annual
rates. This undermines the control of monetary                growth of broad money. Estimations are done based
aggregates to attain desired inflation target.                on annual data series for 1966 to 2004 which are
    Inflation targeting requires an operational               taken from IMF Financial Statistics CD ROM,
framework to guide the central bank authorities in            showing the following results:
conducting monetary policy. This framework                            gpa = 4.52 + 0.522 gma1
consists of a reasonably well-established channel                             (1.4) (1.5)
between policy instruments like money supply and                      R = 0.07, F=1.3, ρ = 0.19
                                                                        2

inflation, relative effectiveness of different monetary           Figures in the parentheses are t-ratios. r is
instruments and the lags involved in the effectiveness,       autocorrelation coefficient of the first order.
a methodology to produce inflation forecasts using                The result shows that the explanatory power of
different approaches, and a forward-looking                   money to inflation is very low over the sample period.
operating procedure that derives an optimal policy            The coefficient is statistically insignificant. Alternative
rule—the central bank’s reaction function—by which            estimation based on broad money as the explanatory
changes in the instrument depend on deviations of             variable gives similar result:
the inflation forecast (the intermediate target) from                 gpa = 4.56 + 0.444 gma2
the inflation target (Khan, 2003). In a country like                           (1.2) (1.4)
Nepal where supply side is prominent in determining                   R = 0.05, F=0.93, ρ = 0.18
                                                                        2

inflation and where currency substitution has been                This result also shows that the explanatory power
taking place in a faster way, observed monetary               of broad money to inflation is further low. The
instruments are less likely to affect inflation.              coefficient is statistically insignificant. When money
    It is argued that inflation-targeting approach            price relationship is very weak, and when a credible
appears to be very promising for developing                   alternative policy instrument does not exist, the room
countries. It is opined that it compels policymakers          for inflation targeting becomes irrelevant. Even though
to deepen reforms, enhance transparency, improve              we take core inflation for targeting purpose, the
the fiscal stance, and eventually converge to                 empirical relationship does not strongly support the
international level of inflation. As the experience of        view. By adopting core inflation as the target and
inflation targeting in several countries indicates, central   achieving this, the central bank can technically
banks must keep the public informed about their               perform its responsibility, but it will be severely
policies and performance in order to attain these             challenged by the public when it fails to control
objectives.                                                   headline inflation.
    Nepal’s monetary policy objectives as defined in              Empirical analysis shows that inflation in Nepal
the NRB Act, 2002 include more than inflation                 is explained by a number of variables like Indian
control. Special tie with the Indian economy tends            prices, real gross domestic output, exchange rate and
to synchronize many macroeconomic variables                   so on. Specification of this type of equation along
between the two countries. The exchange rate peg is           with monetary variable can better explain inflation.
serving the country well in terms of containing               The following estimating equation and the estimated
inflation and attaining external sector stability.            result substantiates this:
Empirical estimation of the determinants of inflation            gpa =co + c1 gma1 + c2 ggdpa + c3 gwpia + c4 gexratea
reveals very weak relationship between money and                  where g gdpa= annual growth of real gross
prices. If inflation targeting is exercised in such a         domestic product, gwpia = annual growth of Indian
situation, choice of an appropriate alternative               wholesale price index, and gexratea = annual changes
monetary variable has to be worked out. This is               of nominal exchange rate of the Nepalese currency
because money supply is less likely to help contain           against US dollar (a positive growth is depreciation).
inflation directly.                                           All the variables are annual averages and the period
    The following equation is estimated to see how            covered is 1966 through 2004.
much of the variation of inflation is explained by                The empirical estimation of the above equation
money supply alone:                                           has produced the following result:
                                                                                         MONETARY POLICY      289

    gpa =1.50 + 0.415 gma1(-1) – 0.110 ggdpa                       gpa = do + d1gwpia or gcpiia
            (0.5) (1.13)               (-0.43)             where gcpiia is annual average of Indian CPI. The
            + 0.517 gwpia + 0.089 gexratea                 estimated result taking Indian CPI as explanatory
               (3.6)*             (0.88)                   variable is mentioned as follows:
    R2 = 0.353 F = 3.4 DW = 2.1                                    gpa = 3.29 + 0.589 gcpiia
    Monetary variable was lagged by one period in                         (2.6)* (4.5)*
the estimation as the current money supply variable            R = 0.377 F= 10.6 DW = 1.54
                                                                 2

had even weaker relationship with inflation.                    ρ = 0.03 Period: 1967 to 2004
    The following section will explore the actual lag          This result means that Indian CPI alone can explain
in the effectiveness of money to contain prices. All       more than one-third of Nepalese inflation. The
the explanatory variables together explain little over     coefficient on Indian CPI or gcpiia implies that each
one-third of inflation in Nepal. Among the                 one-percentage point increase in CPI in India would
explanatory variables, only Indian inflation is            cause a 0.59 percentage point increase in consumer
statistically significant to explain inflation in Nepal.   prices in Nepal. The estimated equation using Indian
    There has been a shift in the money-price              WPI as the explanatory variable shows the following
relationship over time. Estimation of the above            result:
equation in two sub sample periods shows significant               gpa = 4.66 + 0.427 gwpia
differences in some of the relationships. The                              (3.3)* (2.9)*
estimated equations for 1966 to 1985 and 1986 to               R2 = 0.210 F= 4.67 DW = 1.61 ρ = 0.08
2004 give the following result:                                The explanatory power of this equation is less
Period: 1966 to 1985                                       than that of the former implying that Indian CPI
    gpa =1.54 + 0.89 gma1(-1) + 0.14 ggdpa                 can better explain inflation in Nepal. However so
            (0.5) (1.5)                (0.4)               far as the lagged effect is concerned, one period
            + 0.295 gwpia –0.267 gexratea                  lagged Indian WPI explains more of the inflation in
               (1.8)**         (-1.5)                      Nepal than one period lagged CPI of India. This is
    R2 = 0.42 F = 2.6 DW = 1.92                            obvious because pass-on of WPI inflation of India
Period: 1986 to 2004                                       to Nepal takes more time than the CPI inflation due
    gpa =21.6 –2.19 gma1(-1) –0.007 ggdpa                  a time gap involved between wholesaling and retailing
           (2.8) (-2.5)*             (-0.2)                of trading items.
            + 0.299 gwpia +0.325 gexratea
                                                           Lags in Monetary Policy
               (1.2)           (3.2)
                                                              Lags in monetary policy are long, and the future
    R2 = 0.717 F = 8.1 DW = 1.8
                                                           effects of policy actions are uncertain. Therefore
    A few distinctly different relationships have been
                                                           the central banks must anticipate the effects of its
observed in the result of these two periods. First, the
                                                           policy actions well into the future. Behavioral
role of money in explaining inflation seems to be
                                                           changes in money demand, money illusion,
significantly reduced in the second period compared
                                                           imperfection of the market, and long time involved
to the first one. As such one period lagged money is
                                                           in the transaction of goods services and money
exerting negative impact on inflation, contrary to
                                                           affect this lag. Three types of lags are identified in
theoretical expectation. Second, the role exchange rate
                                                           the implementation of monetary policy: (i)
seems to be crucial in determining inflation in the
                                                           recognition lag, (ii) implementation lag and (iii)
second period compared to the first one. This is
                                                           effectiveness lag. When data and information flow
obvious for a number of reasons like more frequent
                                                           in a time lag, the identification of the problem or
devaluation / depreciation of the Nepalese rupee since
                                                           recognition of the action to be taken is delayed.
mid 1980s and rapidly growing share imported goods
                                                           The execution lag takes place when policy makers
in GDP during this period. Third when exchange rate
                                                           and board directors of the central bank cannot meet
change is active, the direct impact of Indian wholesale
                                                           frequently to make real time decisions. The
price on Nepalese inflation is blurred.
                                                           effectiveness lag occurs on account of the structure
    One noteworthy question whether Indian WPI
                                                           and stage of financial development of the
or CPI affects Nepalese inflation more has also to
                                                           economy.
be addressed. The following equation explains this:
290    NEPAL RASTRA BANK IN FIFTY YEARS

    Globally it is recognized that there is a substantial   five to six month’s time and the effect starts declining
lag in the effectiveness of monetary policy. It is          there after. The effect becomes very insignificant after
observed that it takes a year before monetary policy        8 months.
actions have their peak effect on inflation (Batini and         As the explanatory power of estimating equation
Neslon, 2002).                                              with narrow money has higher R2, it corroborates
    Empirical analysis of the money-price lagged            the findings that narrow money is still better policy
relationship is estimated with the following equation:      variable than broad money.
       gcpi = a0 + a1 PDL (gm1, α, γ)
                                                            The “Impossible Trinity” and Dilemma of
    where gcpi = monthly inflation rate, gm1 =
monthly narrow money growth rate, α is lag
                                                            Nepal’s Monetary Policy
operator and γ is constraints imposed on the lag.                The impossible trinity is achieving three things at
The data are taken from IMF Financial Statistics CD         the same time: exchange rate stability, free flow of
ROM.                                                        international capital and an autonomous monetary
    The estimation of the above equation with α =           policy (which means the ability to target inflation and/
8 and α = 2 shows the following result:                     or interest rates). It is not possible for straightforward
   gcpi = -0.04 – 0.024 gm1 + 0.023 gm1(-1)                 reasons: if capital is free to move in and out, and the
           (-0.3) (-1.2)      (1.7)                         exchange rate is fixed, then money can swing in and
      + 0.059 gm1(-2) + 0.083 gm1(-3) + 0.095 gm1 (-4)      out in huge quantities and play havoc with domestic
         (5.7)*            (8.3)*        (9.3)*             inflation and interest rates — which then rules out an
      + 0.096 gm1 (-5) + 0.086 gm1 (-6)                     autonomous monetary policy. Similarly if interest rate
          (9.6)*           (8.4)*                           is targeted, monetary aggregates might move beyond
      + 0.064 gm1 (-7) + 0.031 gm1 (-8)                     desired level (depending upon interest elasticity of
         (4.9)*            (1.6)                            money or credit demand) having its implication for
    Sum of coefficients of the lagged values of gm1         external sector balances. In a perfectly open economy
= 0.514, R2=0.164 F= 30.8                                   case, excess or deficient money supply would then
       Time period: 1964:10 to 2004:07, 478                 change the course of capital flows, ultimately
observations after adjusting end points.                    thwarting the target of interest rate level.
    Figures in the parentheses are t-ratios and * means          In developing countries, monetary policy has
significant at 5 per cent level.                            become increasingly important in recent years, even
    The result reveals that the effect of money on          though capital accounts have been progressively
prices begins right from the second month of                liberalized. The reason is that the large movements
monetary expansion, the effect is maximum in five           in global capital during the late 1990s forced many
to six month’s time and the effect starts dissipating       of these countries to abandon fixed or closely
there after. The effect becomes insignificant after 8       managed exchange rate regimes. Such recent
months.                                                     developments have put a new face on an older,
    Choosing monthly broad money supply growth              deeper lesson: namely that freely mobile capital,
(gm2) as the monetary variable, similar result has been     independent monetary policy, and fixed exchange
observed. The estimated result is as follows:               rates form an impossible trinity. It is opined that it is
   gcpi=-0.46 + 0.016gm2 + 0.068gm2 (-1)                    possible to have any two of these policies, but not
         (-2.2)* (0.5)        (3.2)*
                                                            all three.
      + 0.105gm2 (-2) + 0.129gm2 (-3) + 0.137gm2 (-4)
                                                                 There is a view that real interest rate has to be
        (6.4)*             (7.8)*       (8.1)*
      + 0.132 gm2 (-5) + 0.112 gm2 (-6)                     positive in order to encourage financial savings
         (8.0)*          (6.8)*                             mobilization. So there is a temptation to control
      + 0.078 gm2 (-7) + 0.029 gm2 (-8)                     interest rate along with targeting monetary aggregates.
         (3.7)*            (0.9)                            Targeting an inflation of less than 5 per cent and
   Sum of coefficients of the lagged values of gm2          attempting to maintain interest rate at a level close to
= 0.810, R2=0.122 F= 22.0                                   that in India means that both interest rates and money
   This result also shows that the effect of broad          supply have to be at the disposal of the authorities.
money on prices begins right from the second month          In a market related monetary and financial structure,
of monetary expansion, the effect is maximum in             this cannot be attained through direct interventions.
                                                                                          MONETARY POLICY       291

Take the exchange rate case next. The central bank          employment opportunities. Control of inflation
has traditionally tried to defend the peg with Indian       would also have a direct support on the efforts to
currency. That policy still holds, which means that         reduce poverty.
the central bank wants one of the legs of the trinity:          Monetary policy has a re-distributive role along
stable exchange rates. At a time of high capital flows,     with the promotion of growth. As rising inequality,
more frequent interventions have to be made to              for a given level of income, leads to greater poverty,
defend the current peg. Non-sterilized interventions        the distribution of income is also a central concern.
in the foreign exchange market then have serious            Given the importance of macroeconomic policies,
implications for monetary aggregates which impinge          and the influence of monetary policy in particular, it
upon prices and balance of payments.                        is natural to ask if monetary policy can be used as a
    Talking about the third aspect of the impossible        tool to help the poor through both the income
trinity that is free flow of capital, Nepal has so far      generation and redistribution effects.
loosely maintained capital control. But institutional           Empirical studies (Romer and Romer, 1998;
capital flows mainly through the banking system and         Romer, 1998) suggest that there are indeed important
from the private sector individuals towards India           links between monetary policy and the well-being
remains unregulated. Thus, if the domestic rupee is         of the poor in both the short run and the long run,
ruling stronger than what the central bank would like,      but that the short-run and long-run relationships go
and if there is cross border difference in interest rates   in opposite directions. Expansionary monetary policy
even in fixed exchange rate regime, there is a              aimed at rapid output growth is associated with
possibility of strong capital flows from/to the             improved conditions for the poor in the short run,
country which would affect directly the exchange rate       but prudent monetary policy aimed at low inflation
or would indirectly affect the same through the             and steady output growth is associated with enhanced
balance of payments.                                        well-being of the poor in the long run. Monetary
    In an economy with shallow domestic financial           policy can affect output, unemployment, and inflation
system and high potential for capital flows, monetary       in the short run. As a result, if poverty and inequality
targeting for inflation control and exchange rate           respond to these variables, monetary policy can affect
targeting to defend the peg would be a difficult task       the well-being of the poor. Furthermore, because
for the central bank. In the similar vain, defending a      unanticipated inflation can redistribute wealth from
peg would imply a loss of autonomy in monetary              creditors to debtors, monetary policy can also affect
operation. This means that NRB has perhaps some             income distribution through this channel.
times in future to make a hard choice between                   There are views that in the short ter m,
breaking the peg and loosing monetary autonomy.             expansionary monetary policy can generate a
                                                            temporary boom, and hence a temporary reduction
Monetar y and Financial Policies and
                                                            in poverty. But, as unemployment returns to the
Poverty Reduction: Is There any Relevance?                  natural rate, poverty rises again. Furthermore, the
Monetary Policy—Its Rationale for Poverty                   expansionary policy generates inflation. If a monetary
Reduction                                                   contraction is used to reduce inflation, the adverse
    The basic objective of monetary policy is               effects on poverty offset even the temporary
economic stability – both internal and external.            reduction in poverty during the earlier boom. In the
Economic stability implies containing inflation,            long run, monetary policy most directly affects
stabilizing the interest rate and the exchange rate which   average inflation and the variability of aggregate
would promote investment for economic growth.               demand. Therefore, the important question from the
Along with stability, monetary policy can help              perspective of monetary policymakers concerned
economic growth by ensuring adequate liquidity in
                                                            with the condition of the poor is whether there is a
the economy to generate demand for goods and
                                                            link between these variables and poverty and
services, and a broad based high economic growth
                                                            inequality. Notwithstanding this, monetary policy that
is a must for poverty reduction. Besides, targeted
credit program would help credit allocation to the          aims to restrain inflation and minimize output
poor and desired sectors of the economy, thereby            fluctuations is the most likely to permanently improve
directly promoting their income earning and                 conditions for the poor.
292    NEPAL RASTRA BANK IN FIFTY YEARS

     The short-run effects of monetary policy can            found that a one- percentage point rise in average
influence the well-being of the poor through three           inflation is associated with a reduction in the poor’s
channels. First, and most important, the rise in average     average income of about 9 percent. Thus, on average,
income in a cyclical expansion directly reduces              the poor are much better off in countries where
poverty. Since expansionary monetary policy raises           monetary policy has kept inflation low and aggregate
average income in the short run, this is a powerful          demand growth stable3.
mechanism through which monetary policy can                      There are a number of empirical studies done in
immediately benefit the poor. Second, there may be           Nepal on the effect of monetary policy on inflation
cyclical changes in the distribution of income. The          (see Sharma, 1987; Khatiwada, 1994, etc). But there
declines in unemployment and increases in labor force        are no studies to empirically link inflation with
participation and in real wages in an expansion are          poverty. This section evaluates the relationship
likely to be concentrated disproportionately among           between money supply and inflation in Nepal and
low-skilled workers. Thus the income distribution            inferring the experience of other countries which have
may narrow. Third, the inflation created by                  established an inverse relationship between inflation
expansionary monetary policy has distributional              and poverty, observes that monetary policy has so
effects. Inflation can harm the poor by reducing the         far limited role in poverty reduction. But for creating
real value of wages and transfers.                           a conducive environment for investment and growth,
     For economists sidelining with regulated financial      monetary policy has definitely helped maintain
system, monetary policy has its direct role to play          macroeconomic stability.
like providing subsided food credit for assisting in             The relationship between money supply and
moderating prices of coarse cereals and pulses,              inflation is weak in Nepal. This reveals that money
concessional lending to agriculture, particularly the        supply has very limited role in determining inflation
small farmer for increasing food production,                 in Nepal. There are other domestic and external
subsidized micro credit for the generation of self-          variables like domestic supply side costs, imported
employment, etc. China is one example where state            prices and exchange rate which influence the inflation
led financial services created massive non-farm              rate. From the low money supply-inflation
employment in the rural sector in china during the           association, it can be inferred that monetary policy
1980s and 1990s. All activities in relation to enhancing     has little to affect poverty through inflation.
agricultural growth, non-farm employment, micro
                                                             Monetary Policy, Credit Availability and
enterprises and so on, were supported by
appropriate policies, including subsidized credit. As
                                                             Outreach of the Poor
a result, poverty was reduced to 6 per cent of the               One of the channels of monetary policy to affect
population by the end of the two decades. There              the real economy is credit availability. An expansionary
are other country cases also where directed credit           monetary policy would widen this channel and thus
has had significant impact on employment creation.           help output growth using credit as a factor of
Empirically it is observed that high inflation and           production. But there is not an automatic and strong
macroeconomic instability are correlated with less           linkage between credit flow of the banks and
rapid growth of average income and lower income              economic growth. Credit should flow in the
equality (Romar and Romar, 1998). An “anticipated”           productive area for it to promote growth. What type
increase in inflation of one percentage point is             of growth is promoted by such credit and how the
associated with a decline in poverty of 0.2 percent.         credit is distributed among economic agents has a
However, the contraction needed to reduce the                bearing on poverty.
inflation rate is larger than the expansion that increased       There has been a rapid expansion of the financial
it, so the boom-bust cycle raises average poverty.           institutions along with financial liberalization.
     In a comparison of 66 countries2, it is found the       Subsequently, commercial banks’ credit flow rose
average income of the poor tends to be lower in              from 16 percent of GDP in 1985 to 26 percent in
countries where monetary policy has produced higher          1995 and further to 46 per cent in 2004, one
average inflation and greater macroeconomic                  percentage point each year. Of the total credit flow,
volatility. And ignoring countries with high rates of        share of the private sector improved from 52 per
inflation — more than 25 percent annually – it is            cent in 1985 to 79 percent in 2000 and remained at
                                                                                           MONETARY POLICY      293

74 per cent in 2004. This is encouraging, as                 the borrowing. The poor have to resort more to
government has not been a factor to crowd out                such source. Only 8.3 per cent of the poorest
resources available for the private sector in the recent     consumption quintile had access to bank credit in
years.                                                       2004, almost the same as in 1996; whereas 26.8 per
    Distribution of private sector credit of the banks       cent of the richest consumption quintile has access
shows growing share of the industrial share in total         to such credit in 2004 compared with 21.8 per cent
bank credit. This is encouraging from the perspective        in 1996.
of industries creating employment and thus helping               The collateral based lending practice of the banks
poverty reduction. However, industry has so far not          has been a factor denying access of the poor inn
been able to absorb large labour force. Agriculture,         bank credit. In 2004, 28 per cent of the bank loan
which absorbs more than two-thirds of the labour             went free of collateral compared with less than 12
force, is mostly out of the reach of formal financial        per cent in 1996, a remarkable transformation in eight
services. Of the total credit extended by commercial         years. But that is yet to encompass most of the poor.
banks, only 4 percent went to agriculture in 2004.           Beside, the lower the consumption group of
Agriculture Development Bank, which is a major               households, the higher has been the proportion of
supplier of rural credit, has somehow been extending         borrowing for consumption. In 2004, 58 per cent
credit, but access of the poor households to such            of the borrowing of the poorest consumption
credit is also limited. A taxing lending rate of the         quintile went on consumption compared with 62 per
latter has further adversely affected the agricultural       cent in 1996. This implies that these households have
borrowers.                                                   to meet their basic consumption needs by incurring
    There has been more than three fold increase in          debt. This raises a fundamental question as to whether
per capita credit of the commercial banks in less            the improvement in consumption financed by
than a decade. There has been an expansion of credit         indebtedness sustains the well-being of the poor
from other financial institutions, financial                 households or not. As such, rural indebtedness has
cooperatives, and financial NGOs as well. But the            been one of the reasons for growing landlessness,
available statistics is not very encouraging, indicating     migration and even emigration in search of work
that the level of intervention has been rather small.        abroad.
    The living standard surveys done in 1995/96 and              On the whole, liberal monetary policy — working
in 2003/04 show that borrowing households (from              through interest rate liberalization, deregulation of
both the formal and informal financial system) have          portfolio restrictions, removal of credit ceilings, and
increased from 61 per cent in 1996 to 69 per cent in         withdrawal of other regulations – has been able to
2004. Of the borrowing households, only 15 per               have easy credit expansion to trade and industry. But
cent borrowed from the banking system in 2004                bank financing was confined to limited urban-based
compared with 16 per cent in 1996 (see Table). This          business activities and credit expansion concentrated
implies that households having access to bank credit         in a few business houses. There was a large misuse
have very marginally gone up from less than 10 per           of the easy credit, as evidenced by the non-
cent in 1996 to 10.4 percent in 2004. Moneylenders           performing assets of the two large banks rising to
and relatives account for more than 80 percent of            60 per cent level in 2004. Such credit was not able to

 Household Borrowing and Access to Bank Credit
 Description                                                                        1995/96             2003/04
 Households with Borrowings (%)                                                         61.3                 68.8
 Borrowing from Banks (%)                                                               16.1                 15.1
 Borrowing from Relatives (%)                                                           40.8                 54.5
 Borrowing from Money Lenders (%)                                                       39.7                 26.0
 Proportion of Poorest Quintile having access to Bank Borrowing                          8.2                  8.3
 Proportion of Richest Quintile having access to Bank Borrowing                         21.8                 26.8
 Source: NLSSI and NLSS II, CBS (1997, 2004).
294    NEPAL RASTRA BANK IN FIFTY YEARS

promote growth by enhancing the productivity of            inflation, a typical case of an open and small economy.
investment, nor was it supportive to income                However, as economic sophistication deepens further
generation and creation of jobs for the poor. The          with opening of the economy and financial
liberalization of interest rates in 1989 left no room      deepening, macroeconomic relationships are bound
for subsidized credit to targeted sectors or groups        to shift. A structural shift in the economy would allow
of people. The priority sector credit programme,           the central bank to move from multiple objectives
which included agriculture, cottage and small              of monetary policy to a single one. But whether it
industries and basic service sectors, continued to be      will be inflation or exchange rate depends on the
in place as the mandated lending requirements of           nature of the shift it might take. A move away from
the banks. But the requirement that at least 12 per        monetary aggregates to new instruments of monetary
cent of bank credit should flow towards these              policy will also depend on the changes of basic
priority sectors was often not met. Banks took it as       macroeconomic relationships.
an imposed programme and after a lot of
                                                           Endnotes
opposition, it is now being phased out. This is likely        1 This article is a part of the ongoing research on
to deprive the rural households from the bank credit
                                                           monetary policy of Nepal Rastra Bank (draft).
in the absence of alternative formal institutions. While      2 Christina D. Romer and David H. Romer
bank financing is still confined to a few business
                                                           (University of California, Berkeley), “Monetary Policy
houses, the vast majority of the households remain
                                                           and the Well-Being of the Poor,” Economic Review,
deprived of any type of formal institutional credit
                                                           First Quarter 1999, Federal Reserve Bank of Kansas
(UNDP, 2004). Besides, the lending practice remains
                                                           City.
highly collateral based, thus undermining the access          3 Ibid
of the poor in bank credit.
                                                           References
Conclusion
                                                           Acharya Meena, Yuba Raj Khatiwada, Bikash Satyal
    There have been noteworthy structural shifts in
                                                              and Shankar Aryal (2004), Structural
the Nepalese economy in the recent decades. The
                                                              Adjustment Policies and Poverty, IIDS,
composition of GDP has changed with services
                                                              Kathmandu.
sector emerging as nearly the largest sector, trade-
                                                           Alesina, A and Summers, L.H. (1993), “Central Bank
GDP ratio has increased, foreign exchange regime
                                                              Independence         and     Macroeconomic
has been liberalized, and much monetary and financial
                                                              Performance: Some comparative Evidence,”
deepening has taken place. But some fundamentals
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for the exercise of monetary policy have not yet
                                                              25, No. 2.
changed. Nor the relationships between
                                                           Batini, N. and E. Nelson (2002), The Lag from
macroeconomic variables of Nepal and India like
                                                              Monetar y policy Actions to Inf lation:
prices, interest rate and exchange rate have diverged
                                                              Friedman Revisited, External MPC Unit, Bank
significantly. So long as Nepal continues to have
                                                              of England
current trade, payments, and foreign exchange regime
                                                           Capie, F. and Inood, G.E. “Central Banks and
with India, there is not much maneuverability in the
                                                              Inflation: An Historical Perspective, Part 1”,
country’s monetary policy as well. Structural changes
                                                              Central Banking, Vol. 11, No. 2and 3
in the economy seem to demand shift in
                                                           Central Bureau of Statistics, HMG, Nepal. (1997,
macroeconomic policies as well; but the room for
                                                              2004), Nepal Living Standard Survey.
such a policy shift in the near future remains fairly
                                                           Cukierman, A. and Webb, S.B. (1995), “Political
limited.
                                                              Influences on the Central Bank: International
    Special characteristics of the Nepalese economy
                                                              Evidence,” The World Bank Economic Review
imply that monetary policy continues to have more
                                                              Vol.9, No.3.
than one objective to meet. They are attaining price
                                                           Fisher, S. (1994), “Modern Central Banking”, in the
and external sector stability. These objectives are so
far mutually consistent, exchange rate changes                Future of Central Banking: The Tercentenary
affecting more inflation than trade and money supply          Symposium of the Bank of England, Cambridge
growth affecting balance of payments more than                University Press.
                                                                                  MONETARY POLICY     295

Friedman, M. (1994), “Do we need Central Banks,”      Kuwar, K. B. (2005), “Role of Micro-finance in Rural
   Central Banking, Vol. 5, No.1.                        Development of Nepal”, Agricultural Credit,
IMF (1996) “Nepal: Improving Financial Markets           Vol. 38, Agricultural Development Bank, January.
   and Instruments”, A Report submitted to Nepal      Lindgren, C.J. and Duenas (1994), “Strengthening
   Rastra Bank.                                          Central Bank Independence in Latin America” in
Khan, M.S.(2003), “Current Issues in the Design and      Frameworks for Monetary Stability; Policy
   Conduct of Monetary Policy”, Paper prepared           Issues and Country Experiences, eds. Balino,
   for the RBI/IGIDR Fifth Annual Conference on          and Cohorelli, C. IMF.
   Money and Finance in the Indian Economy,           Nepal Rastra Bank (1972), Rural Credit Review
   Mumbai, India.                                        Survey, Nepal Rastra Bank.
Khatiwada, Y.R (1985), “An Analysis of the            Nepal Rastra Bank (1989), Multipurpose
   Determinants of Inflation in Nepal”, Nepalese         Household Survey Survey, Nepal Rastra Bank.
   Economic Journal, Tribhuvan University,            Nepal Rastra Bank (1996), Forty Years of the
   Kathmandu, 1985.                                      Nepal Rastra Bank, 1956-96, Nepal Rastra
Khatiwada, Y.R (1992), “Monetary Approach to             Bank.
   Balance of Payments, Its Applicability and         Romer, Christina D. and David H. Romer (1998), “
   Implication for Nepal”, Economic Review,              Monetary Policy and the Well-Being of the Poor”
   (Nepal Rastra Bank Occasional Paper),                 NBER Working Paper no. 6793, Cambridge,
   Kathmandu, 1992.                                      Massachusetts.
Khatiwada, Y.R (1994), “Targets, Instruments and      Romer, Christina D. and David H. Romer ( 1999),
   Transmission Mechanism of Monetary Policy in          “Monetary Policy and the Well-Being of the
   Nepal”, Development Vision, Economics                 Poor,” Economic Review, First Quarter 1999,
   Department, Tribhuvan University, Patan               FR Bank of Kansas City.
   Campus, Nepal.                                     Sharma, G. N (1987), Monetary Structure of the
Khatiwada, Y. R.(1994), Some Aspects of                  Nepalese Economy, South Asian Publishers,
   Monetary Policy in Nepal, South Asian                 Delhi.
   Publishers, Delhi.                                 Stals, C. (1993), “A Practical Approach to Central
Khatiwada, Y.R (1996), “Estimating Demand for            Bank Independence,” Central Banking, Vol. IV,
   Money in Nepal: Empirical Issues”, Economic           No. 3.
   Review, Nepal Rastra Bank Occasional Paper.        UNDP (2004), The Macroeconomics of Poverty
Khatiwada, Y.R (1999), “Options for Exchange Rate        Reduction: The Case of Nepal, Asia Pacific
   Policy for Nepal” in Options for Exchange             Regional Programme on the Macroeconomics of
   Rate Policies in Least Developed ESCAP
                                                         Poverty Reduction, United Nations Development
   Countries, ESCAP, Thailand.
                                                         Programme.
Khatiwada, Y.R (2000) “Autonomy of the Central
                                                      World Bank (2002), Nepal: Financial Sector Study,
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   Banks: A SEANZA Perspective, Central Bank             Private Sector Finance division, SASFP, South
   of Sri Lanka, Colombo.                                Asia Region, The World Bank.
296    NEPAL RASTRA BANK IN FIFTY YEARS




                                     Economic Research
                                            Deependra B. Kshetry
                               Executive Director, Currency Management Department
Introduction                                                            statutory obligations of the bank with
     Nepal Rastra Bank (NRB), the central                               regard to its publications will be presented
bank of Nepal, furnishes information on                                 in the subsequent section. The third
monetary, financial and capital market of                               section deals with the detailed
the country. It has been designated as the                              enumeration of each type of materials
economic adviser of the government by                                   produced, for example, the statutory and
the Act governing it. In that capacity, the                             non-statutory works. The fourth section
central bank needs to be competent                                      elaborates on the coverage of the
enough to comprehend the entire                                         publications hitherto continued by the
economic activities, besides the aspects                                NRB. The fifth section suggests measures
directly related to its core functions. For discharging     to fine tune the existing works and upgrade them.
its duties both in the capacity as the monetary authority   The final section presents the conclusion.
and the economic adviser to the government, the             Relevance and Significance
NRB requires up-to-date information on relevant
                                                                Statutorily, the NRB is bound to submit a report
fields for undertaking comprehensive analysis. The
                                                            on its activities and financial position. Section 93 of
normal ways to have access on information are to
                                                            the Nepal Rastra Bank Act, 2002 has the provision
conduct studies, research works and surveys and
                                                            of submitting the audit report, reports on economic
bring them out for public use. The NRB, since its
                                                            and financial position and its activities to the
inception, has been performing statutory obligations
                                                            government within four months of completing the
of submitting annual reports to the government on
                                                            fiscal year. The balance sheet of the bank is also to
financial and economic activities. Similarly, to keep
                                                            be made public within four months of completing
abreast with the economic, financial and capital
                                                            the fiscal year. Similarly, section 94 of the Act has
movement in the country, the NRB occasionally has
                                                            made it compulsory to make public the monetary
been conducting sur veys on such aspects as
                                                            policy of the bank at the beginning of the fiscal year.
household budget and credit needs in the economy.
                                                            The content of the report should include the review
Occasional papers on contemporary issues also are
brought out to supplement the theoretical exercises         of the monetary policy adopted in the previous year
in order to facilitate the bank in discharging its          and analysis with justification for the proposed policy.
statutory as well as other normal duties.                       As per Section 12 of the Act, the NRB has to
     The organization of the paper is as follows. The       disseminate the information on macro economy,
relevance and significance of the statutory and non-        development in financial market, money supply, price
                                                                                     ECONOMIC RESEARCH      297

stability, balance of payments, extension of credit      the NRBhas to go to different custom points to gather
and foreign exchange etc to the public. Most of this     trade data. On the services account, information is
information is generated within the bank, while some     collected from various agencies such as tourism (for
are based on the banking and financial systems           domestic and international airlines, for instance, it is
emanating from the instructions of the central bank.     necessary to disaggregate the account of passengers
The information on money supply, in fact, depends        into residents and non-residents). Hotels, travel
on the reporting of the commercial banks. Note           agencies, transportation agencies are required to
chests have been set up in 71 locations of the country   supply data for incorporation into the BoP statistics.
in order to meet the contingencies of the funds to       On the transfer account, the commercial banks and
conduct government transactions. Of the total            agencies responsible for remittances play crucial role
locations 8 are operated by NRB offices, 43 by the       in reporting the position. Commercial banks often
Rastriya Banijya Bank (RBB) and 20 by the Nepal          take the reporting exercise as a ritual one and
Bank Limited (NBL). The provision of note chest          anticipate reminders from the NRB. The information
covers 68 districts including remote districts such as   contained in the capital account of the BoP is
Darchula and Dolpa where infrastructures such as         collected from the reporting of the banking system
telephone and electricity are absent. The means of       as well as the government agencies, especially for
communications, wherever available, is not regular       government drawings and loan repayments. The
and in most cases not available at all. In these         compilation of the BoP statistics is an exercise vested
circumstances, the information contained with regard     on the central bank but accomplishment of which
to the bank’s activity such as money supply is largely   depends on the timely reporting of the information
constrained by the inadequate data available from        by the concerned agencies. Collecting information
field offices of the commercial banks. Despite efforts   through diverse sources make it difficult for the
by the commercial banks (where note chests have          publications to come out on schedule.
been set up) to dispatch the information, the NRB            The NRB publishes statistics on trade, consumer
either receive the information on the use of such        price index and wholesale price index regularly.
funds late or do not receive any information at all.     Besides these, the macro economic indicators are also
Paucity of data occasionally hampers in meeting the      brought into notice of the public in general as part
deadline of publishing and/or making public the          of the responsibility of the central bank entrusted
information by the NRB.                                  by the Act. Section 69(4) of the Act makes the bank
    Foreign exchange regulations and balance of          mandatory to submit a pre-budget review report to
payments (BoP) compilations are exclusively within       the government each year on economic and financial
the jurisdiction of the NRB. Part of the functions of    matters. The report thus submitted assists the
the central bank in respect of the transactions of       government to comprehend the prevailing economic
foreign exchange has been delegated to commercial        and financial system and adopt appropriate policy
and development banks and money changing                 through budget presentation.
agencies. They need to make timely and correct               The information thus collected and compiled in
reporting to the NRB. To plan for the better use of      a standard format by the NRB together with its
rare foreign currency, it is important to understand     interpretations and analysis forms part of the
the supply and demand sides of it which again            materials to be used by policy makers and planners.
depends on the commercial banks and other financial      The NRB, thus, has been discharging the duty of
entities transacting foreign currency. The regular       publishing relevant materials entrusted by the Act as
supply of accurate information on foreign exchange       well as other information, which normally are
transactions by agents dealing on it largely depends     handled by agencies other than the central bank in
upon the analysis and reporting of the NRB to the        other countries. Supplying price information by a
public in general.                                       central bank does look awkward because
    Similarly, for compiling the BoP data the central    information on money supply comes from the NRB.
bank again has to rely on the information supplied       It seems strange that the monetary authority is dealing
by various national and international agencies. For      with price statistics. Compilation of trade statistics
current account transactions of the BoP, the staff of    normally is the task of the Central Bureau of
298    NEPAL RASTRA BANK IN FIFTY YEARS

Statistics, but in Nepal’s case it has been taken care      69(4) of the NRB Act 2002, submits to the
of by the NRB since long. The justifications given          government a pre-budget review report which
for the task of compiling price and trade statistics        contains a comprehensive analysis of the economy
by the NRB are monitoring whether or not interest           including recent trends and suggests policies to be
rate is positive in real terms and gauging the foreign      adopted by the government. In its capacity as an
currency liability arising due to imports in the economy    economic adviser to the government such
respectively. At first sight, the reasons seem relevant;    recommendations are made by the NRB; however,
however, the tasks to be borne in respect of price          there is no binding rule that the government should
and trade statistics lie on agencies other than the         follow the suggestions.
central bank. Nevertheless, the surveys and special
                                                            Surveys, Studies and Research Works
studies do assist in identifying the problems and
                                                                The NRB, in pursuit of investigation of problems
suggest ways to address them.
                                                            associated in the credit and banking development,
Publications of the NRB                                     occasionally has been conducting surveys, undertaken
    The materials brought out by NRB can broadly            studies in various fields and conducted research on
be classified into three categories; (i) items under        different aspects.
statutory obligations, (ii) surveys, studies and research
                                                            Surveys
works, and (iii) statistical publications. Each of the
                                                                The major surveys conducted by the NRB are
above categories has significance of its own.
                                                            the Agricultural Credit Survey (ACS) and Household
Items under Statutory Obligations                           Budget Survey (HBS). While the former intended to
    The time frame and contents to be included are          find out the drawbacks that remained in the
specified by the Act. The economic and financial            agricultural finance, the latter aimed at gauging the
report which has to be submitted to the government          expenditure pattern of Nepalese family in order to
under section 93 of the NRB Act 2002 should cover           develop the price indices.
areas such as agricultural and industrial output,               The ACS was initiated to conduct a
banking development, government finance, debt               comprehensive survey on agricultural credit on
position, money supply, interest rate movements,            November 15, 1968. An Agricultural Credit Survey
price, trade and BoP in detail with their impacts on        Board was constituted under the chairmanship of
the economy. Along with the economic and financial          Chief Economic Adviser, Research Department with
report, the Act calls for submission of the audit report    other five members representing various agencies
as well as the accounts of the activities of the bank.      including the Central Bureau of Statistics, Agriculture
Besides these annual publications, the bank publishes       Development Bank and Ministry of Food and
its monthly balance sheet within fifteen days of            Agriculture of the government. The Board was
completion of the month.                                    entrusted to direct the organization and supervision
    The economic report deals at length with the            of the ACS, interpret its results and make necessary
overall macro economic aspects of the country and           recommendations on the basis of the findings. The
the annual report contains the administrative functions     Board set the following objectives of the survey: a)
of the NRB. Both reports need to be submitted               to find out the credit needs of different types of
within four months of the completion of the fiscal          farmers based on existing pattern of farming and
year. These reports used to be published separately;        indebtedness of farmers, b) to assess the possibility
but with the introduction of NRB Act 2002, all              of increasing productivity and extension of market
aspects under section 91 and 93 subsection (a), (b)         and c) to explore the ways through which the NRB
and (c) are published in one volume from the FY             could contribute in the field of agricultural finance.
2002/03 onwards. The new Act has also made it                   For the survey purpose, of the 75 districts 32
mandatory to announce and publish the monetary              were selected as accessible (from the transportation
policy to be adopted for the fiscal year for the use        point of view) districts, 20 from Terai and 12 from
of general public.                                          Hills. These districts covered 2006 Village Panchayats
    To assist in identifying the problems inherent in       out of more than 4000. The districts and Village
the economy, the bank under the provision of section        Panchayats actually selected for the survey were 22
                                                                                     ECONOMIC RESEARCH      299

(15 from Terai and 7 from Hills) and 52 (35 and 17         suggested. Close coordination among agriculture
from Terai and Hills respectively) respectively. Thus,     related agencies were advocated so that the resource
the survey covered 59.38 percent of the cultivated         crunch of the agricultural sector would be addressed
area, 42.91 percent of the population and 42.89            satisfactorily.
percent of the Village Panchayats. Altogether 3,195            Development in the field of agricultural credit,
households (2,149 from Terai and 1,046 from Hills)         especially after the survey was over, was distinct as
were selected for the study and interviewed on             ADB and the Land Reform Savings Corporation
matters related to farming practices, credit use and       were merged in 1973 to make a single credit agency
credit needs in future.                                    at the district level. The NRB earmarked a sizeable
    The survey revealed that under the existing            amount to refinance the ADB on medium and long-
farming technology different strata of farmers             term basis. It purchased shares of different agencies
needed Rs. 58.23 million in total in the surveyed          to facilitate agricultural credit. In FY 1978/79 the
districts. The credit need for the large, medium and       NRB purchased Rs. 20 million worth of debenture
small farmers worked out to be Rs. 8.44 million, Rs.       issued by the ADB. An Agriculture Credit Department
10.64 million and Rs. 39.15 million respectively. If       was set up within the NRB to oversee agriculture
the farms were to use improved technology—                 financing specifically.
chemical fertilizer, pesticide, and tractors—the credit        The review survey was conducted during FY
need would be quite different. The survey estimated        1976/77 with objectives of studying the
that the need under improved technology as Rs.             contemporary state of agriculture, especially the
743.60 million ranging from Rs. 163.45 million for         productivity of farm resources. The objectives of
large farmers, Rs. 215.59 million for medium farmers       the survey were also to estimate the credit needs for
and Rs. 364.56 million for small farmers, respectively.    agriculture and agro business together with the
    The survey showed that of the total reporting          agencies supplying credit to the farmer. In order to
                                                           assess credit worthiness of the farmers, the movable
farm families, 48.53 percent had borrowed from
                                                           and immovable assets held by the different farm
money lenders at the interest rate ranging between
                                                           families along with their financial investment and
10 to 50 percent per annum. Similarly, of the total
                                                           capital expenditure were to be examined.
farm families, 42.08 percent acquired loans from
                                                               The number of accessible districts was found out
ward/village committees. Of the reporting 3,025
                                                           to be 39 as against 32 in the previous survey. These
farm families, 84.26 percent expressed satisfaction
                                                           districts were the sampling frame of the survey which
over the work of the village/ward committees. Even
                                                           covered 62 percent of the cultivated area, 66 percent
then the contribution of international sector to
                                                           of the farm households, and 66 percent of the total
provide credit to farmers was very low. Of the total
                                                           population of Nepal. Of the 39 accessible districts,
borrowing by the farm households, 20.87 percent
                                                           35.0 percent (14) were selected from which 7 percent
reported that they had borrowed from the
                                                           from each village panchayat and farm house were
institutional sector like co-operatives, Ward/Village
                                                           drawn. On that basis, 14 districts, 45 village
Committee, Agricultural Development Bank (ADB),
                                                           panchayats and 2655 farm households were selected
Land Reform Saving Corporation and commercial
                                                           under the basis of random sampling technique.
banks whereas the remaining 79.13 percent borrowed
                                                               The survey revealed that the total annual average
from private agencies including friends, relatives and
                                                           gross family income of large and medium size
landlords, etc.
                                                           farmers were Rs. 12,805 and Rs. 7,477 respectively
    The survey projected annual production credit
                                                           while that of small and marginal size farmers were
need based on improved technology to the tune of
                                                           Rs. 5,225 and Rs. 2,821 respectively. The estimated
Rs. 1 billion. The Survey Committee recommended
various administrative reforms including merger of         short, medium and long-term credit needs for all
Land Reform Savings Corporation and the ADB.               the accessible districts for a period of five years
Tasks were given to the government as well as the          (1980/81 to 1984/85) were Rs. 16.32 million, Rs.
NRB to raise capital of the institutions having interest   363 million and Rs. 118 million respectively. A total
on agricultural credit. The refinance schemes and          amount of Rs. 2,303 million including Rs. 190 million
lending by commercial banks to farmers were also           for miscellaneous purposes that was needed for a
300    NEPAL RASTRA BANK IN FIFTY YEARS

period of 5 years was to be taken care of by different     ‘Nepal Rural Credit Review Study 1991-92’ was
financial institutions including the commercial banks.     conducted under the technical assistance of the Asian
During the survey year, 51.26 percent farm families        Development Bank. The main objectives were to
borrowed from different sources. The proportion            undertake a review study to for mulate
of borrowing by farm families was higher in Terai          recommendations and action plan to make the rural
(54.87 percent) as compared to the Hills (42.37            credit system efficient, effective and responsive to
percent). The average borrowing per farm family            the needs of the rural clientele and strengthen the
was Rs. 586, while the large farmers borrowed Rs.          institutional and analytical capabilities of the NRB to
1434 as against Rs. 255 borrowed by the marginal           conduct such studies. In the survey 7,336 rural
farmers. The average debt per farm family was Rs.          households, both borrowers and non-borrowers,
907. The average debt of the large farm family was         from 32 districts were covered. Institutional credit
Rs. 2,367 as compared to Rs. 348 for the marginal          agencies like ADB, NBL and RBB were covered
family.                                                    under the case studies. Besides the line agencies at the
    The proportion of farm families borrowing              district level, officials of the government, the Planning
from private credit agencies was 75.98 percent in          Commission and NRB were consulted.
comparison to just 24.02 percent from the                      The survey estimated that the average annual
institutional agencies. The village moneylenders were      household income in rural Nepal was Rs. 26,000
the single most popular source for credit constituting     ranging from Rs. 17,000 in the case of landless
33.87 percent followed by friends and relatives with       households to Rs. 71,000 in the case of large farmers.
24.24 percent. The beneficiary of the institutional        The contribution of agriculture to the above income
source again was the large farmer as opposed to the        was 54 percent. During the survey undertaken in FY
small and marginal farmers. Interest rates charged         1991/92 the proportion of borrowing by farm
by the different credit agencies varied specially among    families from formal sources was 8 percent only.
the private sources ranging from 10 to 150 percent.        Those borrowing households from the private
But the institutional source recorded a low and            sources accounted for 34 percent and 49 percent
consistent rate of interest ranging from 8 to 18           respectively. The responsible factor for the higher
percent per annum. The requirements of security            percent of informal sector credit was that 81 percent
differed among agencies. According to the survey           of the credit need of the rural people was for social
findings, the institutional sector required 100 percent    and/or consumption purposes which was being
pledging while land, gold and silver were the objects      catered to by the informal sector. Among the formal
of pledging in the private sector.                         sources, the ADB dominated the scene by accounting
    Based on the findings of the survey, a series of       for 85 percent of the rural credit supplied by it.
recommendations including those on institutional           Another reason for its prominence was the Small
charges were made. The Sajha institutions, the grass       Farmers’ Development Project which covered small
root level credit agencies, were recommended to be         and marginal farmers on project basis. The two
governed by the ADB. It was advised to distribute          commercial banks—the NBL and the RBB—
loan to all size of farmers for short, medium and          invested 10 percent of the total credit under Priority
long ter m for production and agro-business                Sector Lending Program (PSLP).
purposes. Commercial banks were asked to follow                The survey recommended the setting up of a
project and area approach in agriculture credit. The       Rural Formal Markets Development Fund where the
NRB was recommended to formulate credit plan               Asian Development Bank would extend soft loan
and undertake study works on loan delinquencies,           assistance of $20 million along with contributions
lending polices and procedures besides earmarking          from the government and financial organizations
significant amount for refinancing. Similarly, relevant    including the Nepal Rastra Bank. In order to improve
measures were sug gested to the government,                the financial health of the institutions, the need for
especially to bring administrative changes in the rural    monitoring and review of the overdue payments at
credit and agriculture financing.                          regular basis was suggested. The capacity building
    As the access to credit by small and marginal          up of the manpower was emphasized in the
farmers in the institutional sector was limited, a third   recommendation by coordination among training
                                                                                      ECONOMIC RESEARCH       301

agencies of the banking sector, for instance,             of age and older representing 77 percent of the total
Agricultural Training and Research Institute (ATRI)       population, 44 percent were found in the labor force
of the ADB, Bankers’ Training Centre (BTC) of the         and the rest were economically inactive. About 22
NRB and the Nepal Administrative Staff College            percent of the male and 42 percent of female were
(NASC). An action plan for the implementation of          engaged in agricultural activities. Similar results were
recommendations was also incorporated in the              found in the other market centers also.
survey report according to which areas of focus and           As a follow up, the survey fieldwork was started
specialization were indicated including the               in mid-March 1984 and ended in mid-February 1985.
implementing agencies and the time frame.                 A slight delay occurred in releasing the survey results
    Since the survey was completed, an agency to          that took place in mid-August 1987. The purpose
promote micro-credit, Rural Micro-Credit                  of the survey again was to find out the changed
Development Centre (RMDC) has been set up to              situation over time occurring due to changes in
oversee and enhance the credit access among the           income and expenditure patterns of the consumers
resourceless farmers and entrepreneurs. The NRB,          for national accounting purposes. Even then the
in line with restructuring and strengthening the          objective set by the survey was to find out the
financial sector, has planned to phase out the priority   population falling below the poverty live.
sector lending which may directly affect the micro-           In the sampling framework, five inaccessible
credit and its delivery mechanism.                        mountain districts namely Manang, Mustang, Dolpa,
                                                          Mugu and Humla were excluded. Out of 70 districts
Household Budget Survey
                                                          and 29 town panchayats, 23 districts and 12 town
    With a view to obtaining a correct weight factor
                                                          panchayats were selected for the study.
in the expenditure pattern of the consumers for
                                                              The average size of household for the country as
constructing reliable consumer price indices, the NRB
                                                          a whole was estimated at 6.11 persons comprising
carried out a household budget survey in eighteen
                                                          6.16 persons for the rural areas and 5.49 persons for
selected market centers in the country during the
                                                          the urban areas. The male female ratio was 50.1:49.9
period 1973-75. The survey results disclosed the social
                                                          for the total population. The survey found 95.5
and economic conditions of the residents living in
                                                          percent of the head of the household having some
the survey areas through their income and expenditure
                                                          type of occupation. The literacy rate for the country
patterns. The survey areas were selected both from
                                                          was 39.6 percent while that for the rural and urban
geographical point of view and their locations
                                                          areas stood at 38 percent and 62 percent respectively.
representing Terai and Hills. Ten main market centers
                                                          Those having dwelling units in the urban areas
from Terai including Mahendranagar and eight
                                                          accounted for 75.7 percent as against 96 percent in
market centers from Hills including Ilam and
                                                          the rural areas.
Okhaldhunga were included the survey. This survey
                                                              The national average monthly household income
was conducted in two phases. Reports were presented
                                                          was estimated at Rs. 1,233 while for rural and urban
separately for each market center. On that basis, the
                                                          Nepal it worked out to be Rs. 1,192 and Rs. 1,785
results of the survey were disseminated separately.
                                                          respectively. At the national level, agriculture income
    The survey findings of Kathmandu center which
                                                          was highest (Rs. 697) comprising 56.2 percent of the
was one of the eighteen centers surveyed revealed
                                                          total income. The next important source of income
that on an average each household consisting of 5.7
                                                          was wages, salaries and non-agricultural income. The
persons consumed Rs. 645 worth of goods and
                                                          consumption expenditure data showed that the
services during the survey year. Of the total expenses,
                                                          national average monthly expenditure was Rs. 1,180
57.4 percent was spent on food while 43 percent
                                                          of which 95.4 percent was spent on consumables
was for non-food items. Housing claimed 11.4
percent of the total expenditure while clothes            and the remaining for non-consumables. The
constituted 8.9 percent of the household expenses.        disaggregated figures for urban and rural household
The sources for meeting these expenses were the           expenditures were estimated at Rs. 1,618 and Rs.
following: 47.5 percent from wages and salaries, 31.2     1,147 respectively.
percent from business profits and 9.5 percent from            Based on the estimates given by the National
income in kinds. Of all household members ten years       Planning Commission for the level of income
302    NEPAL RASTRA BANK IN FIFTY YEARS

required to maintain minimum basic needs, the per          8 percent on non-consumable items. The
capita monthly income for the survey year (FY 1983/        corresponding figures for Kathmandu valley were
84) was estimated at Rs. 160.80 for Hills/Mountains        92.6 percent and 7.4 percent, for the Hills 90.4 percent
and Rs. 125.64 for the Terai. The households falling       and 9.6 percent and for the Terai 92.4 percent and
below the above income level were considered to            7.6 percent respectively.
be below the poverty line. In the Hills and Mountains,         The three household budget surveys provided
47 percent and 36 percent of the households were           enough grounds to incorporate novel items to
found to be falling below the poverty line. In rural       prepare proper weightage for constructing consumer
Nepal, 40.7 percent of the households stood below          price indices. Besides, the socio-economic aspects of
the poverty line. In urban Hills, 12.6 percent household   the households of urban as well as rural areas were
were found to be below the poverty line while this         also revealed. The incidence of poverty was also
figure for urban Terai was placed at 20.2 percent.         examined in one of the surveys in order to facilitate
    The above survey was in fact comprehensive and         the design of a suitable plan by the policy makers to
covered more areas than the previous survey. Due           confront poverty.
to change in pattern of living, changes occurred in
                                                           Other Studies and Statistical Collections
expenditure and income norms, also. Owing to this,
                                                               As the Sajha institutions were the dominant grass
the household budget survey is undertaken normally
                                                           root level financial institutions specially catering to
in the interval of 10 years. During FY 1995/96 the
                                                           rural credit needs, the government emphasized on
‘Household Budget Survey—Urban Nepal’ was
                                                           expanding the network. But there were doubts
conducted with the view that necessary inputs would
                                                           among policy makers especially when such Sajhas
be available to update the existing weightage used in
                                                           came into existence after conversion of village
the consumer price indices. The survey covered 21
                                                           committees. It was thus decided to conduct a survey
urban centers out of 33 municipalities of Nepal. Out
                                                           called ‘Sajha Institutions of Nepal, A Benchmark
of the 29,080 households, 0.8 percent (2,500) was
                                                           Survey, 1983-84.’ The objective of the study was to
selected for the sample.
                                                           provide basic information about multipurpose
    The survey findings revealed that the average
                                                           cooperatives to the policymakers, planners, concerned
family size in urban Nepal was 5.2 persons. The Terai
                                                           agencies and researchers for further study. The
had the largest household size of 5.6 persons
                                                           administrative, financial and marketing aspects of the
followed by 5.1 persons in Kathmandu valley. In a
                                                           Sajha institutions were to be explored through the
household, the sex ratio was 50.8 percent for male
                                                           survey.
and 49.2 percent for female. Of the total urban
                                                               The study covered 2804 villages (1286 in the Hills
population above the age of six, 71.8 percent were
                                                           and 1518 in Terai). One Sajha covered 4 village
literate. By sex, the literacy rate of male and female
                                                           panchayats on average. The average membership per
was 83.3 percent and 59.8 percent respectively. Those
                                                           Sajha was found to be 1883. Those institutions
households owning a house were 70.1 percent as
                                                           extending credit were 85 percent while those dealing
opposed to 24.2 percent living on rented houses in
                                                           with the marketing and selling of chemical fertilizers
urban Nepal.
                                                           accounted 94 percent. The disbursed amount per
    The majority of the urban population (above 10
                                                           Sajha recorded Rs. 124,000 and the proportion of
years old) or 51.4 percent were found economically
                                                           overdue to outstanding loans was 75 percent. The
active. In the valley such population was 49.6 percent
                                                           overdue loan amounted to Rs 249,000 per Sajha of
while in the Hills and Terai, it was 53.4 percent and
51.4 percent, respectively. In terms of income, the        which 78 percent was above one year maturity. Of
Kathmandu valley showed the highest with Rs 10,377         the total number of Sajhas, 69 percent had overdue
monthly average income which was fairly above              loans. Interestingly, the Sajhas made a profit of Rs.
Rs 7,386 of the average urban Nepal. The Hills             9,000 on average as interest receivables were taken
revealed the monthly average income per household          into account. The administrative cost of Sajha was
of Rs 6,240 as against Rs. 6,211 for the Terai. Of the     estimated at 34 percent of the loan disbursement,
total expenditure of Rs. 8,137 in urban Nepal, 92.0        13 percent of the loan outstanding and 10 percent
percent was spent on consumption and the remaining         of the volume of transaction.
                                                                                         ECONOMIC RESEARCH      303

    The study revealed weaker position of the Sajha          to become members of the SFDP. The latter wanted
institutions particularly from the point view of over        the project operated in their areas, too, in view of
dues and administrative costs involved in the operation      the financial and socio-economic gains made possible
of Sajhas. Institutions undertaking marketing as well        by the project. The study suggested replicating the
as loan transactions showed survival symptoms while          program in other parts of the country in order to
those hanging around outstanding loans counting              address the pervasiveness of poverty in rural areas.
income from interest receivables recorded a bleak
                                                             Statistical Compilations
hope.
                                                                 The Quarterly Economic Bulletin is the oldest
    Small Farmers Development Project (SFDP), a
                                                             publication of the Nepal Rastra Bank consisting of
much appreciated project-oriented poverty alleviating
                                                             monetary, banking and exchange rate related statistics
program that was started in 1975, was evaluated by
                                                             that is published regularly. It includes the information
the NRB through a study in FY 1980/81. The
                                                             on transactions of commercial and development
objective of the study was to analyze the agricultural
                                                             banks. Also included are the information on trade
and non-agricultural activities undertaken by the small
                                                             and balance of payments.
farmers. The asset structure and investment made
                                                                 The Main Economic Indicators is published monthly
by small farmers were also to be examined. The
                                                             incorporating the macro-economic statistics with
credit position of the small farmers by sources was
                                                             interpretation and stylized analysis. Commercial Banking
also to be examined. Similarly, the social benefits that
                                                             Statistics is another publication in which detailed
the farmers obtained in course of the project were
                                                             information about the transactions of the
also incorporated into the study.
                                                             commercial banks are given. In line with the
    In assessing the benefits, the project group
                                                             publication of the Commercial Banking Statistics,
(members of the SFDP) were compared with the
                                                             endeavors were made to bring out statistics on non-
controlled group (the non-members). The findings
                                                             bank financial institutions. However, only two issues
were that the group members were far better off
                                                             were out as the department overseeing the non-bank
than those remaining outside the project. The group
                                                             financial institution was merged with the then Banking
members were able to receive loans almost double
                                                             Regulation Department.
the amount of the controlled group. The average
                                                                 Looking at the importance of agriculture in Nepal,
borrowing of the members was Rs. 1,850 in
                                                             the Agricultural Credit Division, under Banking
comparison to Rs. 972 of the nonmembers.
                                                             Development Department used to publish a book
Institutional credit was made available to 62 percent
                                                             Some Important Agricultural Statistics collecting data
of the SFDP members while the corresponding
                                                             from different sources. It ceased to come out with
figure of the non-members was 13 percent only. The
                                                             the closure of the Agricultural Credit Division. Later
area of cultivated land (including irrigated land) was
                                                             on, the areas overseen by the Agricultural Credit
higher with the members compared to non-
                                                             Division were entrusted to the Micro-Credit
members. It indicated the potentiality of expansion
                                                             Department, which seems to put emphasis on project
of the project in the area. The average family
                                                             oriented micro-credit programs.
expenditure was higher with the members compared
to non-members incurring less expenses in food for           Research and Occasional Papers
both the group. Under the social services front such             The role of economic adviser to the government
as education and health, the SFDP group benefited            can hardly be fulfilled if research works on
more than the non-members. The members were                  contemporary economic issues are not taken up.
able to get training such as veterinary, health, education   Nepal Rastra Bank through its various publications
and farming as opposed to non-members primarily              accommodates research articles of the academicians
belonging to organized groups.                               outside from the bank as well the experts from
    The evaluation clearly indicated the benefits of         different departments of the Bank.
the project revealed through the advantages available            One the occasion of the silver jubilee of the
to SFDP members in comparison to non-members.                establishment of the Bank, a publication entitled
The members wanted to continue their involvement             Twenty Five Years of the Bank was brought out covering
with the project while the controlled group aspired          different activities. Similarly, on the occasion of the
304    NEPAL RASTRA BANK IN FIFTY YEARS

fortieth year of the establishment of the Bank, Forty      publication incorporates the narration of activities
Years of Nepal Rastra Bank was published                   done by the Bank during the fiscal year as well as
incorporating major policy decisions and activities        articles of interest concerning economic and financial
during the period.                                         developments. The same division also releases an issue
    The Research Department of the bank has been           of Nepal Rastra Bank Samachar in vernacular with a
bringing out occasional paper under the name of            view to communicate the events to the staff in general.
Economic Review with research articles related to          Relatively thin in size, the monthly administrative news
economic, banking and financial aspects. The priority      item is of immense interest to the staff.
for the contributions of articles has been given to            The Bankers’ Training Centre (BTC) brings out
the staff of the Bank, yet authors from outside the        Prasikchhen covering the programs as well as reporting
Bank are also honored duly. There has been the             of the training programs to the interested persons.
practice of publishing the occasional paper on the         Research articles of interest also are published in the
auspicious occasion of the anniversary of the bank.        publication.
The golden jubilee issue of the occasional paper               The Banking and Financial Institutions Regulation
numbered seventeenth.                                      Department publishes Banking Prabardhan on a bi-
    On the occasion of 49th anniversary of the Bank,       annual basis year accommodating articles mainly
Nepal Rastra Bank brought out ‘Nepal Rastra Bank           concerned with banking promotion, financial
Working Paper’ which was placed in the website for         development and other economic activities.
comments and discussion for the interested groups.             The compilation of circulars, regulations, Acts and
Subjects covered in the paper are the issues related       bye-laws are published by the Bank regularly in most
to activities of the Bank and economic development         cases with a ‘label’ ‘for official use only’ attached on
issues of the country. Also released by the Bank during    them. To highlight the departmental activities, the
the occasion was the book entitled Asian Development       departments bring out publications which are quite
Bank and Nepal highlighting the relationship of the        irregular in nature. Though purely for individual
country with the regional financial institution that has   purpose, the Nepal Rastra Bank’s library compiles
relevance with development of the country.                 the list of new books, magazines and periodicals
    Special publications highlighting the relationship     under the name of ‘Library Awareness’ which helps
with international organizations such as International     the readers to pick up the articles of interest. Similar
Monetary Fund and World Trade Organization are             publications, though not regular, are brought out by
issued by the bank. Two publications, namely, The          the Public Debt Management Department, Financial
International Monetary Fund and Nepal and WTO and          Management Department and Banking Supervision
Nepal were published by the Research Department.           Department. Such publications give a broad outline
                                                           of the activities of a particular department which
Miscellaneous Publications
                                                           may benefit the general readers.
     Each department has a specific role and performs
its functions accordingly. Temptation always remains       Evaluating the Publications
to bring into light the activities of a department.            Statutory obligations to produce annual reports
Therefore, quite a few departments have endeavored         on economy and activities are submitted within the
to bring out publications covering exclusively the         time frame stipulated in the Act. But publishing for
subject matters related to the concerned department.       the use of general public takes a longer time. By the
     The Bankers’ Club is the part and parcel of the       time the material is available, the content of the report
Bank. Each month the Club publishes a literary book        almost becomes obsolete. Information available on
comprising poems, stories, drama and so on. But a          time serves better to address the problems, if any, in
tradition has been set to bring out an issue of Mirmire    the system. Almost all the publications of the Bank
exclusively with articles related to economics and         are free of cost and they are distributed to those
business.                                                  intending to possess the publications irrespective of
     The Public Relations Division of the Bank             the level of understanding of the subject matter.
publishes Nepal Rastra Bank Samachar with articles             The publications that are distributed without any
contributed both by insiders as well as the outsiders      cost follows the status oriented norm. Within the
from the Bank. In the majority of the instances, the       Bank, the normal practice is that all sorts of materials
                                                                                        ECONOMIC RESEARCH       305

including surveys and reports are made available to        are returned to the sender’s address; even then, no
staff up to first class level. It is not necessary that    revision is done to update the mailing list. Therefore,
everyone within that level is interested in every          there is a need to look into the upgrading of the
publication of the Bank. The optimal use of the            publications of the NRB in terms of editing, printing
publication is possible only when the need is identified   and distribution qualities.
and the interested person is ready to pay for it. To           It is found that NRB conducts surveys and studies
bring out materials involves cost. If the time taken       but in some cases the reports are confined to the
for the preparation of the material as well as             draft stage only. By reasons not specified, those
distribution to the public is also considered, the real    reports fail to be disseminated. The study on
cost is much higher than the material cost reflected       ‘Remittances in Nepal’ conducted by the Head Office
in pricing. Therefore, to ensure that the genuine users    and the study on ‘Informal Trade’ undertaken by
find easy access and materials are properly utilized,      the Birgunj Office of the NRB serve best illustrations.
the dissemination system should be altered to suit             The studies financed by the NRB are also not
the contemporary available technology.                     published in full form except for the synopsis. The
    The materials should be made available not only        outsourcing of research work and dissemination of
in printed form but also through the electronic            such reports also could add to the vast knowledge
information system. The genuine users by now are           of national economy.
capable to use the materials, howsoever the bulk that          In publishing the materials, the publishers (in this
may be, if those are placed into website. It may           case the departments) seem to be free so long as the
involve some cost at the initial stage, but in the long    basic norms of the Bank is not violated. Unbridled
run this becomes cost effective in terms of resource       situation like this will raise the printing cost while
use. Relying on electronic device to disseminate           achievements may be limited. No specific time frame
information of the Bank helps in saving the printing       to bring out a publication from a particular
cost of materials which normally is done in two            department is drawn. A circumstance of this nature
languages, vernacular and English. The interested          has put the scenario of Bank’s publication into
persons can obtain the materials required for them         disarray. To make it predictable, a systematized
at all the time using the website.                         publication policy is needed.
    The printed materials are often criticized on the
                                                           Suggested Measures
basis of print quality, use of substandard materials
                                                               The publications of the NRB claim huge financial
and poor binding. This occurs normally for the
                                                           resources, but it is difficult to establish the degree
publications given for print on contract basis. The
                                                           of benefit brought about by the free distribution
quality of materials printed at the NRB’s own press
                                                           system. First, the Bank should decide which way the
is well maintained.
                                                           publications should go; electronic or printing method.
    The editing of publications matters when quality
                                                           Considering the cost involved in printing, distributing
is to be ensured both from cost incurred as well as
                                                           and handling, switching to electronic media is
meeting the expectation of the readers. In the
                                                           worthwhile. No problem arises for distribution.
publications usually brought out during the
                                                           Interested persons may obtain the material easily
anniversary, for example, Nepal Rastra Bank Samachar
                                                           through the electronic device. It is crucial to prioritize
and Mirmire, it seems that no serious attempt is made
                                                           what type of publication should go into website and
in selecting articles for publishing. The articles
                                                           what should be printed.
received for publication are rarely dishonored.
                                                               Until the publications are placed in the website
Incorporation of all types of articles could have an
                                                           completely, the printed materials also will have to be
adverse impact on the quality of the publication.
                                                           circulated. The practice of distributing for free should
    The distribution system of printed materials is        gradually be stopped and a reasonable price needs
not based on objectivity. On the basis of the position     to be charged. Quoting the price is not intended for
one holds, the mailing list is prepared and publications   making a profit nor is to cover the cost; but applying
dispatched at the Bank’s cost. Neither response is         the price means the publications reach the genuine
anticipated nor is the pain of updating the roster         users. This ensures utilization of resources and the
taken. The materials that are unable to be distributed     cost is recovered partially. Disarray in the publication
306    NEPAL RASTRA BANK IN FIFTY YEARS

of materials from different departments has created           To discourage this trend, the policy decision about
problems such as diversity in printing work and lack          the nature, time and quality of publication should be
of systematic and organized endeavor to bring out             made in advance and the schedule should be
the publication on time. There is no control over             maintained accordingly to ensure quality control.
the quality in printing and costs involved. It is therefore       Use of electronic devices needs be speeded up
necessary to handle the printing and publication of           so that modern technology remains in place saving
the important materials from one window. This will            space to store the publications. It assists to clean up
help in reducing the costs and homogenize the quality         the library complex as well as the inventory of the
of printing through one channel within the Bank. If           bank. Electronic media is found to be user friendly
possible, distribution also should be centralized.            and cost saving specially in transmission of the
    The time schedule should be maintained in                 materials to overseas countries.
bringing out the publication. Coordination among                  A provision of introducing a nominal price to
departments could help to consolidate the                     the publications could be made for ensuring proper
publications, and reduce the numbers accordingly.             use of the publications. Only the needy persons will
The paper and print quality should be of high                 hold the required NRB publication—paying the price
standard so that the importance of the publication is         which is not intended to cover the cost but to make
reflected. Due attention should be given to the               sure the use of material in proper perspective. Hence,
contents of the publication.                                  the complementary distribution policy needs to be
    Coordination among different departments in               reviewed.
publishing statistics may also contribute to enhance              Surveys and research studies conducted by the
the quality, promptness and address the need of the           NRB sometimes take a longer time than originally
users. By avoiding duplication, the resources involved        scheduled. Information thus received may lose value
in printing may also be saved. Materials contained in         because of the time factor which would otherwise
the Quarterly Economic Bulletin and Commercial Banking        have been used for policy decision. Reports brought
Statistics are of the same nature in the majority of          out late do not serve the purpose originally planned
cases. The latter presents slightly detailed information      for. In some instances, it has been observed that some
which could be accommodated into the Quarterly                studies do not get published despite heavy
Economic Bulletin. Planned and coordinated work assist        involvement of human and financial resources of
to enrich the quality of content as well as the lay-out       the bank. To discourage this trend, a well-planned
of the publication.                                           time schedule should be maintained regularly so that
                                                              the inputs received from the studies fully serve the
Conclusion
                                                              purpose.
    Through its publications, the NRB reports to the
                                                                  The NRB is striving to focus on ‘core functions’
government about the economy and its activities.
                                                              of the central bank. In this pursuit, many ancillary
Submission of the annual report, auditing report,
                                                              works have to be abandoned and such services need
report on the Bank’s activities and the report on
                                                              to be obtained from service providers. Because of
economic and financial position of the Bank within
                                                              the fact that the Nepalese market is not ready to
four months of the completion of the fiscal year is a
                                                              provide all sort of services according to the aspiration
statutory obligation. Because of this, no lapses remain
                                                              of the clients who normally expect publications of
in this exercise unlike in other publications particularly
                                                              high quality, gradual outsourcing could be the norm.
in maintaining the publishing schedule.
                                                              In these circumstances, no compromise in quality of
    There is an absence of policy regarding
                                                              products and materials should be made. Even the
publication as a result of which the departments bring
                                                              distribution mechanism may be outsourced.
out publications simply with a memo approved by
the higher authority. Exercises of this nature breeds             A huge amount of financial resources is involved
competition among departments leading to inferior             in bringing out the publication of the NRB, but the
quality of the publications. Expenses increase but use        achievement does not seem satisfactory. No
of the materials draw the least attention. As a result,       measuring rod is available to examine the degree of
there is a waste of resources and time ensuring               ser vices provided by the NRB through free
complacency in compromising inferior products, too.           distribution of its publications; however, it is a matter
                                                                                       ECONOMIC RESEARCH       307

of satisfaction that the information contained in the    NRB. 2003. Monetary Policy and Programme for the Fiscal
NRB’s publications are received warmly and treated         Year 2003/04 (in Nepali). Kathmandu: NRB.
as authentic by many public and private bodies           NRB. 2002. Nepal Rastra Bank Act 2002. Kathmandu:
including foreign agencies. There still remains a room     NRB.
to improve the quality and standard of the materials     NRB. 2001. Issues in Exchange Rate Management.
both with respect to content and layout. The resource      Kathmandu: NRB.
use could be optimized through switching the             NRB. 1999. Report on Household Budget Survey: Urban
publication media into the electronic system. The          Nepal. Kathmandu: NRB.
printed items should also be priced also so that         NRB. 1996. Forty Years of Nepal Rastra Bank (1956-
genuine users obtain the materials. As the value           1996). Kathmandu: NRB.
received by the users of the NRB publications is         NRB. 1990. Nepal Rastra Bank Act 1955 (8 th
growing, the bank should make changes through              Amendment Incorporated). Kathmandu: NRB.
policy decisions ensuring quality and timely             NRB. 1987. Household Budget Sur vey Report.
publication.                                               Kathmandu: NRB.
                                                         NRB. 1987. Sajha Institutions of Nepal: A Bench Mark
References                                                 Survey (1983-84). Kathmandu: NRB.
Asian Development Bank and Nepal Rastra Bank             NRB. 1982. An Evaluation Study of Small Farmers
   (NRB). 1974. Nepal Rural Credit Review.                 Development Projects of Nepal. Kathmandu: NRB.
   Kathmandu.                                            NRB. 1980. Agricultural Credit Review Sur vey.
NRB. 2005. Mid-term Evaluation of the Monetary Policy      Kathmandu: NRB.
                                                         NRB. 1977. Activities of Directed Co-operative Institutions
   for the Fiscal Year 2004/05 (in Nepali). Kathmandu:     and Village Committees – Survey Report (in Nepali).
   NRB                                                     Kathmandu: NRB.
NRB. 2003. World Bank Group and Nepal. Kathmandu:        NRB. 1972. Agricultural Credit Survey. Kathmandu:
   NRB.                                                    NRB.
308   NEPAL RASTRA BANK IN FIFTY YEARS




                                    Foreign Exchange
                                         Ram Prasad Adhikary
                     Act. Executive Director, Foreign Exchange Management Department
Introduction                                                        substantial in some cases, thus contributing
     The external sector policy is designed                         to the license holder to make easy money
considering domestic stability and external                         even without undertaking import
competitiveness. However, the external                              business.
sector policy of a country cannot be fully                                The foreign exchange system of a
independent         of     the      overall                         country depends on overall economic
macroeconomic policy. Because of                                    policy being pursued by it. In the pre-
inward looking approach of the country                              liberalization era, the foreign exchange
till the 1980s, foreign exchange policy of                          system was restrictive; as soon as the
Nepal was restrictive as in the case of                             country started to follow the path of
many of other developing countries, particularly the    economic liberalization, the foreign exchange policy
least developed ones. In the controlled regime, the     has been geared towards the same direction. In fact,
exchange rates of foreign currencies vis-à-vis          after entering into liberalization after the mid-1980s,
Nepalese rupee used to be determined officially and     the reform initiated in the foreign exchange front
kept unchanged for a long period. All the foreign       has been more pronounced than in other sectors of
exchange earnings had to be surrendered to the banks    the economy. There have been substantial changes
at the official exchange rate, in which the rate for    over the years. The major reforms during the period
foreign currency is generally kept low. In such a       include the following: a) determination of the
regime, the national currency normally tends to be      exchange rate by the market forces for all currencies
over valued, thus encouraging imports and               other than the Indian rupee; b) adoption of open
discouraging exports.                                   general license system for imports; and c) substantial
     The foreign exchange system was controlled as      relaxations in foreign exchange regulations.
well and one had to get permission from the authority   Evolution of Foreign Exchange System
for obtaining even a small amount of foreign currency
                                                            The foreign exchange system of Nepal can be
other than the Indian rupee. There was the system
                                                        analyzed on the basis of three broad time frames: a)
of issuing import license for importing goods from
countries other than India. Normally, such practice     the period prior to the establishment of the Nepal
tended to be favorable for influential people as it     Rastra Bank (NRB) in 1956, b) the period from 1956
was easy for them to obtain the license. There was      to the pre-liberalization period; and c) the period
the practice of selling such license with premium,      after liberalization.
                                                                                           FOREIGN EXCHANGE      309

The Period Prior to the Establishment of the                  there was any restriction to purchase and sale IC nor
NRB                                                           any license required for entering into such business.
    There was widespread circulation of the Indian            Even though the government used to intervene in
currency (IC) during this period. The IC was not              the foreign exchange market by fixing the NC/IC
only performing as a medium of exchange but was               exchange rate from time to time, considering the
also accepted as a store of value by the people based         trends in the fluctuations of the exchange rate, the
on geographical, economic and social proximity                rate fixed by government could not be reflective to
between the two countries. Due to lack of                     capture the market rate. The IC/NC exchange rate
transportation facilities, many parts of the country          was fully at the mercy of the limited number of
were not as integrated as compared to today. Before           Sharafs that used to determine the rate through
the construction of Mahendra Highway, it was almost           consultation with one another. They fixed the rate
impossible to travel between East and West Nepal.             on the basis of demand for and supply of IC in the
On top of that, given the then education level and            market. As a result the exchange rate used to change
other attributes, many people may not have had                frequently. It used to be so volatile that often one
knowledge about the Nepalese Currency (NC). In                could see a noticeable change in the rate even within
such a situation it was natural for the people’s              a day (Table 1).
preference of IC over the NC, as many people,                     The Reserve Bank of India (RBI) was the
particularly residents of the border areas, did not           custodian of Nepal’s convertible currency holdings.
have much confidence on the NC. Besides, there                All the convertible currencies of the country used to
was also the absence of legal provisions regarding            be deposited with the banks in India. Consequently,
currency circulation.                                         there used to be no separate convertible currency
    The exchange rate of NC vis-à-vis the IC used             reserves of Nepal. Nepal had to get the permission
to be deter mined by the Sharaf, a business                   from the RBI in order to use its own foreign currency.
community involved in money changing business.                This practice continued till the execution of the first
Anyone could enter into such a business as neither            Trade and Transit Treaty between Nepal and India

 Table 1
 Exchange Rate of Nepali Rupee vis-à-vis Indian Rupee at Kathmandu Market
 (Average rate per 100 IC)

                   First Quarter     Second Quarter   Third Quarter   Forth Quarter      Total     Annual Average
 1942                  102                92                94             97             385            96
 1943                  93                 89                92             90             364            91
 1944                  87                 83                83             80             333            83
 1945                  67                 67                75             75             284            71
 1946                  75                 81                89             92             337            84
 1947                  99                 99               109             105            412            103
 1948                  100                103              109             107            419            105
 1949                  103                103              110             106            422            106
 1950                  104                106              111             114            435            109
 1951                  117                131              137             139            524            131
 1952                  149                155              156             158            618            155
 1953                  160                161              170             167            658            165
 1954                  173                183              179             173            708            177
 1955                  154                156              150             148            608            152
 1956                  136                135              136             145            552            138
 1957                  155                153              161             169            638            160
 1958                  165                163              165             166            659            165
 1959                 155.5              164.5            163.5           148.5           632            158
 Source: Nepal Rastra Bank (1971).
310    NEPAL RASTRA BANK IN FIFTY YEARS

on November 12, 1960. It was only after that Treaty            The name of the Act ´Increase in the Circulation
that the convertible currency earnings of Nepal started    of Nepalese Currency´ itself implies its objectives. It
to be deposited at the NRB’s account.                      was enacted in order to establish the Nepalese rupee
                                                           as the only one legal tender. Yet, many practical
After NRB´s Establishment in 1956 to the
                                                           aspects, including the provisions regarding foreign
Pre-liberalization Period                                  exchange transactions, necessary for its effective
    After its establishment in 1956, the NRB took          implementation, were missing in the Act. Therefore,
the initiative to address the above-mentioned              notwithstanding the above provisions, it was not that
weaknesses that persisted in the foreign exchange          easy to abolish the dual currency system by merely
system. In this connection, the Bank had to a)             declaring the Nepalese rupee the one and the only
eliminate dual currency system, b) bring stability in      one legal tender, unless some pragmatic measures
the exchange rate, c) regulate the foreign currency        acceptable to general people were adopted, given
transactions, and d) manage the foreign exchange           the practice of widespread use of IC. Thus, there
reserves of the country. These issues are examined         was the enactment of the Control of the Foreign
below.                                                     Exchange Transaction Act, 1960. The Act had come
Elimination of Dual Currency System                        up with many provisions regarding foreign exchange
    The top priority accorded by the NRB in the            transactions. The Act made it mandatory to get the
initial period of its establishment was to do away         NRB’s permission to deal in foreign exchange. The
with the dual currency system by inculcating               Act also restricted an individual for accepting or
confidence in the NC. The NRB acknowledged the             providing any foreign exchange from/to any
fact that without abolishing the dual currency system,     individual other than a license holder. Besides, the
effective foreign exchange management and the              exchange rates to be used for foreign exchange
implementation of independent monetary policy              transactions were not allowed to be different from
would not be possible.                                     those prescribed by the NRB.
    Realizing the need of sufficient legal authority for       The legal provision alone was not sufficient to
attaining the above objectives, the following acts were    change the deep-rooted practice being used by the
promulgated one after another: a) the Increase in the      people. Such a practice demanded a practical
Circulation of the Nepalese Currency Act, 1957, b)         approach acceptable to the people. Hence, the
the Control of the Foreign Exchange Transaction            authority initiated the following measures: a) fixation
Act, 1960, and c) the Foreign Exchange (Regulation)        of NC/IC exchange rate at Nepalese Rupees (NRs.)
Act, 1962.                                                 160 per 100 Indian Rupees (IRs.) effective from
    The legal constraints were resolved to a large         April 13, 1960; b) commitment of the NRB to buy
extent after the promulgation of these acts. For           and sale any amount of IC at the exchange rate fixed
example, the provisions enshrined in the Increase          by it, thus introducing the system of unlimited
in the Circulation of the Nepalese Currency Act,           convertibility of IC; and c) establishment of a large
1957 could be considered enough for abolishing             number of exchange counters throughout the
the dual currency system by making the Nepalese            kingdom in order to make the exchange facility for
rupee one and only legal tender. The Act, among            Indian rupees easier and convenient with the
others, included the following provisions: a) one          arrangements of conducting these counters from
should accept the Nepalese currency for all the            early in the morning to late in the evening.
transactions including the ones determined in                  The promulgation of the two acts together with
terms of foreign currency using the exchange rate          the adoption of above measures helped contain the
of the NRB; b) the settlement of borrowing/                circulation of IC to some degree. Although some
lending in the foreign currency should be made in          of the basic legal requirements needed for foreign
Nepalese rupee using the existing exchange rate            currency transactions were met by the Control of
of the NRB prevailing on the day of the                    the Foreign Exchange Transaction Act, 1960, there
transactions; and c) the violation of the above            existed no provisions that were adequate for
provision would result in a penalty extending from         effectively regulating foreign exchange. Therefore,
Rs. 100 to Rs. 1000.                                       another Act, namely the Foreign Exchange Regulation
                                                                                         FOREIGN EXCHANGE      311

Act 1962 came into force on August 17, 1963,                commercial banks and financial institutions also to
repealing the Control of the Foreign Exchange               engage in foreign exchange transactions. HMG shall
Transaction Act 1960. The new Act is in force till          consult the Bank while fixing such par value (Clause
date with two amendments—first amendment on                 21 Sub-clause 1) and, b) HMG may frame regulations
October 18, 1987 and the second on August 7, 2002.          or issue orders relating to foreign currency control
    The promulgation of the Acts together with the          in consultation with the Bank (Clause 21 Sub-
initiation of the above measures proved successful          clause 2).
in reducing the circulation of IC in the country to             Looking at the above one may argue that since
some extent. However, instances of IC circulation           all of the power regarding foreign exchange rests
persisted to a large extent in the Terai areas till 1966,   on the government, the status of Bank is confined
when India devalued its currency. This was because          to be simply an implementer of the policy being
even in those trading centers where the Foreign             formed by HMG. Similar inference can be drawn
Exchange Regulation Act was in operation, holding           from the Foreign Exchange Regulation Act, 1962 as
of the IC was legally allowed and this prevails till        well. The clause 15 of the Act states “In case it is so
date. When the IC holding is not illegal and could be       deemed necessary for implementing the purposes
used easily, it was natural for the people in the Terai     of this Act, HMG may from time to time issue
region to hold the IC in the context of the long open       general or special instructions to the Bank, and the
border, free movement of people from/to India,              Bank shall comply with such instructions in relation
social, cultural, religious proximity etc. Moreover, the    to matters or actions under this Act.”
people were of the firm belief that IC would emerge             However, as a specialized entity in this field, the
stronger than NC and there would be a devaluation           Bank could influence HMG sufficiently in
of NC against the IC and not vice versa. This               determining the exchange rate as well as framing
expectation might have also prompted them to hold           regulations regarding foreign exchange transactions.
IC. Therefore, when people have plenty of IC, which         Though, as in the case of many other countries in
used to be easily acceptable for making any kind of         the world, the power to fix the par value and frame
payment, it is understandable that legal restrictions       regulation or issue orders relating to foreign currency
alone were not sufficient to do away with IC                control were kept with HMG, it was bound even
circulation.                                                legally to consult the NRB in doing so. This shows
    Nepal did not devalue its currency even in the          that though the de jure power was still with HMG,
face of substantial devaluation of the Indian rupee         the Act had made the NRB the de facto authority on
by India on June 6, 1966. Consequently, the exchange        matters relating to the fixation of the exchange rate
rate of the Nepalese rupee vis-à-vis the Indian rupee       and framing necessary rules and regulations regarding
appreciated remarkably. Accordingly, the exchange           foreign exchange. Therefore, it was the responsibility
rate moved to NRs. 101 per IRs. 100 from the existing       of the NRB to make necessary arrangements in this
rate of NRs. 160 per IRs. 100, with the IC holders          connection including the exchange rates of the
incurring huge unexpected exchange losses. This             Nepalese rupee vis-à-vis foreign currency.
development not only contributed to the                         On the one hand, the Nepal Rastra Bank Act 1955
surrendering of the IC holding of general public to         itself had made the Bank de facto authority in matters
the banking system, but also made them reluctant to         relating to foreign exchange including exchange rate
hold the IC unnecessarily. Subsequently, the circulation    determination and, on the other hand, the exchange
of IC came virtually to an end.                             rate of IC determined by the Sharaf used to be quite
                                                            volatile as elaborated above. Furthermore, since all
Stability in the Exchange Rate System
    With respect to foreign exchange, the Nepal Rastra      the convertible currency holdings of Nepal used to
Bank Act 1955 had stated the following:                     be deposited with the banks in India until the
    (a) The Bank shall have the right to deal in            execution of the first Nepal India Trade and Transit
transactions between Nepalese currency and foreign          Treaty on November 12, 1960, neither the private
currencies at the exchange rate fixed by it from time       sector was involved in dealing with those currencies
to time on the basis of the par value fixed by His          nor HMG had felt the necessity for determining the
Majesty’s Government (HMG). It may authorize                exchange rates for such currencies. Therefore, the
312    NEPAL RASTRA BANK IN FIFTY YEARS

Nepalese foreign exchange markets composed of                payments to India. While abolition of the dual
only the Indian currency during that period.                 currency system and elimination of multiple exchange
    As stated above, the major transactions of IC            rates of Indian rupee was the first concern, Nepal
used to be conducted on the basis of exchange rate           not only fixed the exchange rate of Indian rupee at
determined by the private sector. HMG also used to           NRs. 160 per IRs. 100 and made it applicable for all
fix the rate but that was applicable only for the            purposes, but also introduced the system of free and
purpose of importing certain specified goods. In this        unlimited convertibility of Indian rupee effective
context on March 17, 1956, that is, before the               from April 13, 1960. Subsequently, the banks in Nepal
establishment of the NRB, HMG had fixed the                  started to make Indian rupees available as per
exchange rate of Nepalese rupee at NRs. 175.50 per           demand emanating from various quarters at the fixed
IRs. 100 and authorized the Nepal Bank Limited,              exchange rate. As a result, the multiple exchange rate
the only Bank operating in the country, to make              system was done away with.2
available the required Indian rupees for trade purpose           The introduction of the system of fixing the
only. For all other purposes it was required to procure      exchange rate of IC at NRs 160 per IRs 100 emerged
IC at the free market exchange rate, which used to           successful. Primarily due to favorable trade balance
change frequently, as elaborated above. Therefore,           with India, the IC holdings of the country kept on
addressing the exchange rate issue was one of the            increasing through 1965 except for a marginal drop
important concerns for the NRB. Thus, within the             in 1963. Meanwhile, India devalued its currency by
time frame of less than two months of the Bank               as high as 36.5 percent on June 6, 1966. Because of
establishment, that is, on July 1, 1956, the authorization   the comfortable level of the IC holdings and also
of conducting Indian currency business was                   with a view to immunize the Nepalese economy from
transferred to the NRB with the fixation of the Indian       the likely inflationary effects of the IC devaluation,
rupee’s exchange rate at NRs. 150 per IRs. 100.              Nepal did not devalue its currency despite a huge
    It is well known that Nepal has been following           devaluation of IC. This resulted in appreciation of
two sets of policies regarding the exchange rate—            the Nepalese rupee by about 37 percent against the
one for Indian rupee and another for convertible             Indian rupee. The new exchange rate was, thus, fixed
currencies.                                                  at NRs 101 per IRs 100.
    (a) Policy Regarding the Indian Rupee:                       The decision not to devalue Nepalese rupee
Certainly, the absence of exchange rate of the               contributed a lot in eliminating the problem of dual
Nepalese rupees vis-à-vis other foreign currencies was       currency, as the overnight loss in the value of IC not
not a pleasant situation for the central bank of a           only resulted in a significant loss to the IC holders,
country; the primary concern, however, was to make           but confidence about the Indian rupee also shattered.
the IC/NC exchange rate stable which was imperative          As a result, people started to exchange the Indian
even for eliminating the dual currency system as             rupee with the local currency thus contributing in the
elaborated above. At the time of the establishment           authorities´ effort in increasing NC circulation all over
of the NRB, HMG had fixed the exchange rate of               the country.
the Indian rupee at NRs. 154.50 per IRs. 100, but                As expected, Nepal could not sustain such an
that rate was not applicable for all transactions. It        appreciated value for a long time as shown by
was only for the purpose of importing certain                subsequent deterioration in the trade balance with
specified goods. For all other purposes, people had          India, resulting in a substantial fall in IC reserve. While
to resort to free market rates determined on the basis       the decline in the IC reserves was exerting pressure
of demand and supply.1                                       to HMG, the devaluation of Sterling Pound on
    Against this background, the elimination of the          November 19, 1967 by 10 percent put further
multiple exchange rates was a precondition even for          pressure. It is to be noted that although a substantial
instilling confidence of the general people, particularly    proportion of Nepal’s trade used to be conducted
those residing in the Terai, in the Nepalese rupees. A       with India, Nepal had been pursuing the policy of
necessary condition required the abolishment of the          expanding its trade with overseas countries and the
dual currency system and also for ensuring the people        policy was gradually gaining momentum. In such a
about the easy availability of IC for making the             situation, the appreciated currency was certain to hurt
                                                                                           FOREIGN EXCHANGE       313

the economy. Therefore with a view to maintaining            exchange rate has changed (revaluation or devaluation)
the competitiveness of its goods in the world markets        only through the discretionary decision.
including India, Nepal devalued its currency by 24.8             (b) Convertible Currencies: Nepal has been
percent on December 8, 1967, thus setting the new            adopting a significantly different methodology in case
parity at Rs. 135 per IRs 100. From this period to           of exchange rates of convertible currencies. The
November 30, 1985, when the rate for Indian                  NRB started to buy and sell the convertible currencies
currency was set maximum at NRs 170 per IRs 100,             from 1960, four years after its establishment. Initially,
the exchange rate of Nepalese rupee against Indian           HMG used to fix their exchange rates in Indian rupee
rupee went through three revisions (Table 2).                term on the basis of exchange rates prevailing in
    Until November 1985, the NRB used to fix the             India. The official rates and the market rates of IC
buying and the selling rates on the basis of parity          in Nepal used to be different as stated above. Since
fixed by the government. The policy of parity fixing         it was not practicable to fix the rates in terms of
by HMG underwent a major change on May 31,                   Nepalese rupees in a situation of multiple exchange
1986. It was decided to include all the currencies,          rate system, HMG used to fix the rate in Indian
including the IC in the basket and the NRB started           rupees. When the multiple exchange rates system
to quote its buying and selling rate of IC on a daily        came to an end after Nepal initiated a move to
basis. Theoretically, the inclusion of the IC in the         provide free and unlimited convertibility of the
basket implied that its exchange rate could also change      Indian rupee by fixing the exchange rate at NRs. 1.60
on the daily basis. In practice, however, it has not         / IRs. effective from April 13, 1960, Nepal started
undergone changes on that basis for a single time. Its       to quote the exchange rates of convertible currencies


  Table 2
  Discretionary Change in the Exchange Rate of the Nepalese Rupee vis-à-vis Indian
                      Exchange Rate of
  Date                Rupee/Unit of IC          Remarks
  Apr 13,1960                  1.60             Fixation of the new rate after the establishment of NRB with
                                                the introduction of free and unlimited convertibility of IC
  Jun 6,1966                   1.01             A marked appreciation of about 37 percent of Rupee due to
                                                the decision of the government not to follow the Indian path
                                                of sharp devaluation of its currency.
  Nov 8,1967                   1.35             Devaluation of the rupee as explained in the text.
  Dec 22,1971                  1.39             Following the realignment of currency on Dec, 17 1971, the
                                                exchange rate of NC/IC was also revised along with Pound
                                                Sterling, Deutsche Mark and Japanese Yen effective from Dec
                                                22, 1971.
  Mar 22,1978                  1.45             -
  Nov 30,1985                  1.70              14.7 percent devaluation of Nepalese rupee against the foreign
                                                currencies.
  May 31,1986                  1.68             It was decided to also include IC in the currency basket system
                                                effective from June 1, 1983. The previous practice of setting
                                                the buying and the selling rate of IC on the basis of parity fixed
                                                by the government were done away with. NRB started to quote
                                                the buying and the selling rate of IC also on a daily basis as in
                                                the case of other currencies.
  Jul 1,1991                   1.65             -
  Feb 12,1993                  1.60             Adjustment due to change in India.
  Source: NRB (1996) and Quarterly Economic Bulletin.
314    NEPAL RASTRA BANK IN FIFTY YEARS

in terms of Nepalese rupee itself effective from May        and it was decided to leave the matter of exchange
14, 1960, as it was no longer necessary to fix the          rate to the NRB through the adoption of a system
rates in Indian rupee terms. At first, the exchange         known as the currency basket system. Accordingly,
rates of only three currencies, that is, US dollar, Pound   effective from June 1, 1983, the Nepal Rastra Bank
Sterling and Swiss Franc used to be quoted by the           introduced the trade-weighted basket of currency
NRB. The Japanese Yen was included in the list from         system.4
August 1961. It is to be noted that some of other                With the introduction of the currency basket
non-convertible currencies, besides Indian rupee,           system, the NRB was authorized to change the parity
namely Burmese Kyat, Malaysian Ringgit and                  of the rupee/ US dollar exchange rate, and if
Pakistani rupee also used to be quoted. The list kept       required the exchange rate of the rupee vis-à-vis the
on increasing and reached 17.3                              US dollar was allowed to change on a daily basis.
     Though Nepal had to adopt a different exchange         The US dollar started to float. Though the name of
rate system in case of Indian rupee due to the              the countries and weight of the respective currencies
attributes mentioned above, the system with rest of         assigned in the basket were not disclosed, the
the currencies has been, by and large, in line with the     principal trading partners including India may have
international practice. Along with other countries in       been included. In view of the higher share of the
the world, Nepal was following the system of fixed          country’s trade with India, the Indian rupee might
parity prior to the collapse of Breton Woods System.        have been given higher weight. Theoretically, inclusion
The system was brought to end in accordance with            of the Indian rupee and US dollar in the basket means
the Smithsonian agreement. Subsequent to this, all          allowing these currencies’ exchange rate to change
the important currencies were realigned under a             on a daily basis and there were instances of such
floating system. Nepal also opted for the system,           changes in case of the US dollar. The case was
but it could not be effective because of the pegging        different in case of the Indian rupee since due to the
of the Nepalese rupee to the US dollar. The exchange        importance of maintaining the fixed parity with this
rate of the Nepalese rupee vis-à-vis the US dollar          currency, the frequent revision in its exchange rate
did not witness any change until and unless it was          was almost ruled out. Furthermore, because of the
devalued or revalued by HMG. The exchange rates             status of intervention currency given to the US dollar,
of other currencies, however, used to change because        the exchange rates of all other convertible currencies,
of the practice of calculating such rates on the basis      as usual, continued to be determined on the basis of
of the exchange rates of these currencies in the            international cross rates with the US dollar.
international market.                                            As mentioned above, the value of the US dollar
     At the beginning of 1980s, the global economy          used to change, but the frequency and the magnitude
was going through significant ups and downs,                did not capture the pace as in the case of the
accompanied by wide changes in the exchange rates.          movements of the exchange rate of the Indian rupee
Meanwhile, India de-linked its currency from the fixed      vis-à-vis the US dollar. From the introduction of
parity with Sterling Pound and floated its currency.        this system on June 1, 1983 to its formal burial on
As a result, the IC exchange rate in terms of the US        March 4, 1992 through the adoption of partial
dollar started to change almost on a daily basis. As        convertibility of the Nepalese rupee, the exchange
the Nepalese rupee was having fixed parity with both        rate of the US dollar moved to Rs 43.10 from Rs
the US dollar and the Indian rupee, the broken cross        14.20—an increase Rs 28.90 per US dollar. But not
rate started to emerge between the US dollar/IRs.           all the increase did take place under the grab of the
and the Nepalese rupee. Sometimes, the magnitude            basket system. Nepal had devalued its currency thrice
of the broken cross rate used to be too large. In           within the period. This shows that of the total change,
order to rectify this, there was no alternative other       Rs 10.40 was through the government’s devaluation
                                                            decision and Rs 28.80 was through the gradual
than taking discretionary measures of devaluation or
                                                            adjustment under the system (Table 3).
revaluation of the US dollar exchange rate. However;
                                                                 The Indian economy was passing through a
the decision of this nature by HMG normally took            period of serious crisis towards the beginning of
its own time. So it was felt that this sort of procedure    the 1990s. Its foreign exchange reserves had fallen to
was not adequate to meet the challenge of the day           a rock bottom level. The Indian rupee thus went
                                                                                        FOREIGN EXCHANGE      315

 Table 3                                                   unlimited convertibility of Indian rupee. Further, it
 Exchange Rate of Nepalese Rupees/                         was also not justifiable for Nepal to revalue the
 US Dollar (Mid-Rate)                                      Nepalese rupee vis-à-vis the Indian rupee given the
     Mid –Month                        Mid-Rate            persistent trade gap and consequent pressure on
                                                           Indian rupee balance in the banking sector. Thus,
     1965 July                               7.64          Nepal decided to follow the Indian path of
     1966 July                               7.64
                                                           devaluation. However, considering the likely
     1967 July                               7.64
     1968 July                              10.15          inflationary pressure, Nepal opted to take a two-
     1969 July                              10.15          way prescription: a) the parity for Indian rupee was
     1970 July                              10.15          brought down to Rs 165 from Rs 168, and (b) the
     1971 July                              10.15          US dollar exchange rate moved up to Rs 42.70 from
     1972 July                              10.15          Rs 38.00.5
     1973 July                              10.55
     1974 July                              10.55
                                                           Regulations for Providing Foreign Exchange
     1975 July                              10.55              Nepal’s foreign exchange system was strictly
     1976 July                              12.50          controlled as in the case of many of other developing
     1977 July                              12.50          countries in the world until the beginning of the
     1978 July                              12.00          1990s when the country embarked upon the
     1979 July                              12.00          liberalization era. Generally, the foreign exchange
     1980July                               12.00          policy of a country trails behind the overall economic
     1981 July                              12.00          policies. A country cannot pursue a completely liberal
     1982 July                              13.20          foreign exchange policy if the overall economic
     1983 July                              14.50
                                                           policy is a restrictive one. Encouraging exports,
     1984 July                              16.40
     1985 July                              17.70
                                                           protecting import substitution industries and
     1986 July                              21.20          discouraging imports were the main thrust of the
     1987 July                              21.90          external sector policy of the country before it entered
     1988 July                              23.60          into liberalization. The import-substitution industries
     1989 July                              27.50          used to be protected providing several facilities
     1990 July                              29.20          including lower customs, tax concessions and rebates.
     1991 July                              42.80          Furthermore, they were enjoying foreign exchange
     1992 July                              42.70          facilities as they were provided foreign exchange at a
     1993 July                              49.24          favorable or special rate. They were benefited with
     1994 July                              49.35
                                                           respect to the exchange rate too, as in an officially
     1995 July                              50.70
     1996 July                              56.53
                                                           determined exchange rate system, the value of
     1997 July                              57.03          domestic currency tends to be generally higher than
     1998 July                              67.93          the actual value.
     1999 July                              68.48              The country has been adopting the trade
     2000 July                              70.75          diversification policy, with special emphasis on export
     2001 July                              75.03          promotion to countries other than India. Given the
     2002 July                              78.30          over concentration of trade with India, it was
     2003 July                              75.05          appropriate to adopt such policy. In addition, efforts
     2004 July                              74.45          have been made to earn more and more of
 Source: Calculated from the data published in Quarterly   convertible foreign exchange and enhancing the
         Economic Bulletin.                                reserve of such currencies. In this connection Nepal
                                                           adopted the following measures in the foreign
through two devaluations in two days. As the               exchange front.
Nepalese economy was not facing the similar crises,            (a) Bonus System : The first measure for the
it was neither justifiable nor sustainable for Nepal       purpose was the adoption of “Exporters Exchange
not to follow the Indian measures without adjusting        Entitlement Scheme,” popularly known as the Bonus
the NC/IC parity in the context of the free and            System. Under this system, those earning convertible
316    NEPAL RASTRA BANK IN FIFTY YEARS

foreign currencies through the export of goods to           policy of the country. The second was the detection
third countries were issued a bonus certificate. Only       of some instances of over invoicing of export and
those having a bonus certificate were eligible for          under invoicing of import due to the second higher
importing from third countries. The bonus premium           rate. Consequently, the dual exchange rate system
rates used to be governed mainly by the demand of           was scrapped from September 19, 1981 by devaluing
goods to be imported from third countries in India.         the Nepali rupee vis-à-vis the US dollar by 9.1 percent.
The bonus system contributed significantly to trade         After that, the new buying and the selling rate of 1
diversification. However, because of some of the            US dollar were set at Rs 13.10 and 13.30 respectively,
inherent weakness such as frequent change in the            lower by Rs. 0.80 in comparison to the second rate.
bonus premium rates, instances of over invoicing                (c) Auction System : Although Nepal could
of exports etc. it was decided to replace the system        achieve some degree of success with regard to trade
by the one known as dual exchange rate system with          diversification, the policy adopted was not that
effect from March 30, 1978.                                 effective and efficient for the overall economic
    (b) Dual Exchange Rate System : The dual                development. The foreign trade policy was
exchange rate system was introduced with a view to          characterized by the requirement of import license,
providing effective incentives to Nepalese exports.         quantitative restrictions, imposition of widely
Two types of exchange rates for the US dollar were          dispersed import tariffs in the name of protecting
fixed. Initially, the buying and the selling rates of the   domestic industries etc. Besides, the officially
first category, which was known as the basic rate,          determined exchange rate used to be favorable for
were fixed at Rs.11.90 and 12.10 respectively and           importers as the value of domestic currency was
the buying and selling rate for the other category (the     generally kept appreciated under such system. This
second rate) were fixed at Rs. 15.90 and 16.10              was substantiated by the existence of substantial
respectively. The basic exchange rate remained the          premium of the US dollar in the black market. All
same throughout the period of the existence of this         these led to the proliferation of trading firms rather
system (from March 30, 1978 to September 19,                than the industries. Certainly, there was the
1981). However, the second rates were adjusted              development of import substituting industries and
downward by Rs. 2 on February, 20, 1980, thus setting       persons involved in establishing such industries might
the buying and the selling rates at Rs. 13.90 and Rs.       have reaped the benefits. But, in view of the little
14.10 respectively.                                         domestic value addition, establishment of such
    Under this system, the basic rate was prescribed        industries was in no way that significant from the
for the transactions falling under the government and       perspective of overall economic development of
service sector, while the second rate was prescribed        the country.
for all the convertible foreign exchange earnings               Over the years, the authorities were also becoming
through export. In case of import from third                convinced with the weaknesses of the controlled
countries, the basic exchange rate was prescribed for       system and were contemplating towards adopting
a list of some specified goods only; for the rest of        an open, liberal and market friendly economic
the imports one had to pay the second rate.                 approach in line with the other developing countries
    Besides contributing to open import trade to            of the world.
some extent as the import license for all the                   The import license auction system was introduced
commodities, excepting for the banned items and             in July 1986, as a first move towards this direction.
those commodities under quantitative restriction,           The goods were classified into different groups and
started to be provided automatically, Nepal’s export        sub-groups. Initially, 88 commodities were included
to third countries also recorded a significant rise. This   in the list, which were classified into three groups.
was the main motive behind this scheme. Viewed              While Group A included essential raw materials,
from this angle only, the scheme could be rated as          Group B and Group C comprised basic consumer
fully successful. However, there emerged some               goods and luxury goods, respectively. Later on, in
adverse effects. The first one was the shift of import      May 1990, Groups D and E were added. Of the
trade towards India. This shift was not a pleasant          additional groups, Group D was meant for goods
one for the authorities given the trade diversification     which were highly liable to deflate to India, and
                                                                                         FOREIGN EXCHANGE       317

Group E included only the consumer goods to be                   The major features of the foreign exchange system
largely handled by small traders. The maximum               of the then controlled regime were as follows: a) no
allocation of licenses was determined on the basis          role was given to the market forces in determining
of estimated demand of the goods to be imported.            the exchange rates of foreign currency; and b) very
    There used to be a large participation of business      complicated procedures were adopted for providing
community, including the small traders. This                all other currencies excepting Indian rupee.
contributed to eliminate the monopoly of limited                 The adoption of such restrictive measures in the
houses in overseas business. The system was so              foreign exchange front could not be termed as
designed that there was the least chance for one to         unnatural given the existence of inward looking
influence the decision as the premium, the main basis       policy of HMG in the other sectors of the economy.
for the licensing decision, used to be fixed by a           Nepal initiated major changes in the foreign exchange
committee set up for the purpose. This system               sector when HMG embarked on the economic
contributed a lot to increase transparency, reduce          liberalization policy. All the facilities including
administrative impediments in this area and facilitated     providing cash incentives to the exporters were
new entrants, aside from generating considerable            eliminated. With the introduction of the OGL
amount of revenue for HMG.                                  system, the requirement of obtaining import license
    Meanwhile, Nepal embarked into economic                 by paying premium was also done away with. The
liberalization policy through the introduction of partial   provision of requirement of recommendation for
convertibility of the Nepali rupee in March 1992.           importing industrial raw material was eliminated.
Notwithstanding the ultimate aim of going for a full-       There have been structural changes in the overall
fledged open general license (OGL) system, it was           economic policy of the country.
not practically feasible to introduce the system in one          The restrictive provisions of the foreign exchange
go. It was decided to gradually reduce the list of goods    policy have been gradually relaxed and made
under the auction system. The list of the goods was         transparent. The major reforms initiated in the
reduced to 43 immediately after the introduction of         external sector policy are discussed below.
partial convertibility. Later on, the number was reduced
                                                            Legal Reforms
to 12 keeping only 6 items under the auction system.
                                                                Though the NRB was entrusted to deal with the
Finally, from July 15, 1993, the six items were also
                                                            matters pertaining to foreign exchange and used to
brought under the OGL. Since then all the items except
                                                            be consulted by HMG to effect any changes in this
for certain specified items like gold, silver, precious
                                                            regard, it was not independent till the enactment of
stone, armaments and narcotic drugs are under the
                                                            the Nepal Rastra Bank Act 2002, and subsequent
OGL and any registered company or firm can import
                                                            second amendment in the Foreign Exchange
any amount of goods through letter of credit.6
                                                            Regulation Act 1962. Certainly, the NRB was given
The Post-Liberalization Period                              the authority by the Nepal Rastra Bank Act, 1955
    Earlier, one had to pass through several stringent      also. It was given authority for dealing in transactions
processes to obtain even a small amount of                  between Nepalese currency and foreign currencies
convertible currency prior to liberalization. It was        at the exchange rate fixed by it from time to time on
not possible to get even 1 dollar without the NRB’s         the basis of the par value of the foreign currencies
permission. The trade regime was restrictive, too.          fixed by HMG and the Bank was also given power
One had to obtain import license that used to be            to authorize commercial banks and other financial
issued by HMG. Obviously, the issuance of license           institutions to engage in foreign exchange transactions
could not be fair always. The license-issuing authority     (Clause 21(1)). NRB, however, was not entrusted to
had some discretionary power, which could be                frame the rules and regulations. There was the
abused off and on. In such a situation procuring an         provision of framing such rules and regulations by
import license was very difficult for a common man,         HMG in consultation with the NRB (Clause 21(2)).
while the case would be different for the ones who              HMG, being the supreme authority of a country
could exert influence of some type, thus contributing       having ultimate power, could influence the working
to concentrate the foreign trade on such influential        of any of the organization, including the central bank.
persons, mainly the big business houses.                    However, in the context of liberalization, keeping
318    NEPAL RASTRA BANK IN FIFTY YEARS

such power with HMG was thought to be                     chance of fostering black market for foreign
inappropriate. Meanwhile, the world climate was           exchange. In such a situation it is natural for foreign
turning in favor of the central bank’s independency.      exchange earners either not to bring the earning into
Thus, the Nepalese authority also decided to make         the country or sell at the black market rather than
the NRB independent and promulgated the Nepal             surrendering to the banking system at a lower rate,
Rastra Bank Act 2002 replacing the earlier one. The       thus adversely affecting the official foreign exchange
Act, besides giving more power to the NRB in other        reserve position of the country and compelling the
areas of its operations also made the Bank fairly         authority to impose further stringent measures.
independent in the foreign exchange front. With this           After the introduction of the partial convertibility
Act the Bank has been the sole authority to formulate,    of the Nepalese rupee in March 1992 and subsequent
implement and cause to implement foreign exchange         full convertibility in February 1993, there has been
policy of Nepal (Clause 62). The Act has given full       substantial change in the exchange rate system of
authority to the NRB in matters relating to: a) issuing   Nepal. Except for the Indian rupee, the exchange
license under this Act or other prevailing laws to the    rates of convertible currencies started to be
person willing to deal in foreign exchange                determined on the basis of demand and supply in
transactions; b) framing rules and bylaws and issuing     the market. The role of the NRB has changed from
necessary order, directives, or circulars in order to     a rate maker to a rate taker. The exchange rate of
regulate dealings in the foreign exchange transactions    convertible currencies started to be determined by
by the foreign exchange dealer; c) inspecting,            the authorized dealers, though the NRB also published
supervising and monitoring the foreign exchange           the exchange rates of foreign currencies for its own
dealer; d) setting base, limitations and terms and        use. However, the rates published by the NRB are
conditions for the transactions of the foreign            only indicative. Each of the commercial banks is free
exchange dealer; and e) prescribing the system of         to determine its own buying and the selling rate for
determining the foreign exchange rates of the             convertible currencies and other near money
Nepalese currency.                                        instruments. The commercial banks are themselves
    More importantly, the Act has also empowered          responsible to fulfill their foreign exchange
the NRB to formulate the bylaws. In addition to           obligations. They have been made free to manage
this, the Act has come up with most of the provisions     their foreign exchange reserves in the international
required for the formulation and the implementation       market.
of the effective foreign exchange policy in the                As the central bank of the country, the NRB
changed context.                                          cannot be indifferent in such an important matter
    Subsequent to the enactment of the Nepal Rastra       relating to exchange rates, however. In this connection,
Bank Act, 2002 there has been a second amendment          though commercial banks are authorized to
in the Foreign Exchange Regulations Act 1962              determine the buying and the selling rate of the foreign
effective from August 7, 2002. Apart from                 currency, the NRB has been successful to make them
removing the irrelevant provisions, the amendments        agree, through moral suasion, in keeping the
have incorporated all of the provisions required for      difference between the buying and the selling rate
implementing foreign exchange policy in line with         within one percent. It means that if a commercial
the spirit of liberalization and globalization.           bank fixes the buying rate lower, accordingly its selling
                                                          rate needs to be lower, too. For example, if Bank A
Exchange Rate Reform
                                                          sets the buying rate at Rs. 70 per unit of US dollar,
    As discussed earlier, the exchange rate used to be
                                                          its selling rate should not be more than Rs 70.70 (one
deter mined officially. The exchange rate so
                                                          percent of the buying rate). Likewise, if Bank B’s
determined may not represent the market as there
                                                          buying rate is Rs. 71, its selling rate cannot cross Rs.
would be no necessary adjustments in the rate for a
long time. There was no self-adjusting mechanism in       71.71.
such a system. The tendencies of the authority would           When banks are allowed to determine the
be to keep the domestic currency at a higher value.       exchange rate, the rates may be different for different
When the value of domestic currency is kept at an         banks. In such a situation, the question may arise
artificially appreciated level, there would be every      with respect to the exchange rate being published by
                                                                                        FOREIGN EXCHANGE      319

the NRB. Normally, the commercial banks in Nepal           rate, the central bank is fully responsible for every
use similar exchange rates, though there have been         issue in the foreign exchange front. No one can claim
some instances of different rates being used by            of market-determined exchange rate to be always
different banks. The commercial banks have                 realistic; sometimes, it may change without any
established an association called the Foreign Exchange     justifications, causing adverse impact on the economy.
Dealers Association (FEDAN) with a view to sharing         There are several instances of adverse consequences
knowledge and avoiding unhealthy competition in            experienced by the countries adopting such an
foreign exchange transactions. Its membership              exchange rate system.
consists of all the 17 banks of the country. One of            The stability, both internal and external, has been
the primary tasks of FEDAN is to work as a bridge          the primary concern of each and every country and
between its members and the NRB in matters relating        such stability cannot be achieved in the face of
to foreign exchange. Each commercial bank is               exchange rate volatility. Thus a central bank, having
required to send its exchange rate to the FEDAN on         the responsibility of foreign exchange management,
a daily basis. The FEDAN collects such exchange            should always focus on maintaining exchange rate
rates and then sends to the NRB. After receiving the       stability by intervening in the market. Certainly, no
exchange rates of all commercial banks via the             central bank can dictate the market in a liberalized
FEDAN, the NRB calculates the average exchange             exchange rate system. However, it can and should
rate for the US dollar; and this average rate is the       influence the market by adopting the indirect means.
exchange rate for US dollar to be published for the        In this context, the NRB can intervene and has been
next day. After computing the exchange rate of the         intervening in the exchange rate market through two
US dollar, the exchange rates for other convertible        means. One, moral suasion itself can be and has
currencies are calculated on the basis of their cross      been an effective tool. For example, because of the
rates with the US dollar in the international market.      moral suasion of the NRB, the spread between the
    Even in the context of giving freedom to the           buying and selling rate could have been maintained
market forces in the determination of the exchange         within one percent limit. Two, the NRB can signal


  Table 4
  Transactions with Commercial Banks Under Intervention
  (Millions of US Dollar)
                                  Purchase from                       Sales to                      Difference
                                Commercial Banks                   Commercial Banks            (Purchase-Sale)
                           Nos.             Amount               Nos.            Amount                Amount
  1991/92                      1                 8.7                 -                0.0                    8.7
  1992/93                      8               110.5                 -                0.0                  110.5
  1993/94                      5                69.6                 4               22.1                   47.5
  1994/95                      -                 0.0                10              163.6                 -163.6
  1995/96                      7                41.8                 8              164.8                 -123.0
  1996/97                      7                44.7                 5               35.1                    9.6
  1997/98                      8                65.6                 6               59.6                    6.0
  1998/99                     15               161.0                 -                0.0                  161.0
  1999/00                      7                70.3                 4               28.2                   42.1
  2000/01                      5                94.8                15              162.1                  -67.3
  2001/02                      9               107.5                 7              102.4                    5.1
  2002/03                     24               323.1                 2                7.8                  315.3
  2003/04                     30               408.7                 3               27.6                  381.1
  2004/05                     36               472.5                 4               50.1                  422.4
  Total                      162              1978.6                68              823.4                 1155.2
  Source: Compilation from Individual Interventions by the Foreign Exchange Management Dept. of NRB.
320    NEPAL RASTRA BANK IN FIFTY YEARS

its view on the prevailing rates to market from the        NRB without making any attempt to get the required
exchange rate it fixes while buying/selling the foreign    funds through the inter-bank. Such arrangement has
exchange with the commercial banks through                 been made so as to develop the inter-bank
intervention.                                              transactions and discourage the individual bank to
     Table 4 shows that NRB has been buying/selling        immediately approach the NRB.
the foreign exchange with the commercial banks
                                                           Institution Building
through intervention at their request since Nepal
                                                           Money Changers
embarked into the liberalization phase. This is
                                                               Foreign exchange transactions used to be carried
necessary in a liberalized exchange rate system;
                                                           out only through the banking system prior to the
otherwise, the objective of stable exchange rate may
                                                           first half of the 1990s. Though some of the entities
not be achieved. If the central bank does not buy/
                                                           such as hotel, travel agencies etc. were also issued
sell the foreign exchange, the foreign exchange dealers,
                                                           licenses; these were only for specific purposes with
that is, the commercial banks may raise/reduce the
                                                           the objective of serving their clients only. Confining
exchange rate frequently to a greater extent, thus
                                                           the foreign exchange transactions to a limited sector
creating uncertainty in the exchange rate, which is
                                                           was not desirable in the liberalized context as one
bound to have a detrimental impact on the overall
                                                           (foreigner) in need of converting the foreign
stability of the economy. Considering the likely
                                                           currency into Nepali rupee would either had to
adverse effect of exchange rate fluctuations on the
                                                           resort to the hotel or to go to a bank. None of the
economy, as done by other central banks in the world,
                                                           options was preferable as exchanging the currency
the NRB is effortful to make the exchange rate stable.
                                                           in a hotel implied not obtaining the actual price for
In the context of freedom in determining the
                                                           his/her foreign exchange and proceeding to a bank
exchange rate, the NRB cannot impose on the
                                                           was even more problematic for a new person.
commercial banks to fix the rate as prescribed by it.
                                                           Therefore, in order to resolve these difficulties, the
However, to some extent it can influence the market
                                                           NRB started to issue license to the private sector
as stated above. To this effect, the NRB, has been
                                                           from 1995. In order to regulate these entities, the
buying and selling foreign exchange through
                                                           Bank brought a directive in 1995 by the name of
intervention in order to maintain the exchange rate
                                                           ‘Money Changers Directives 1995’ into
stability.
                                                           implementation. Money changers have been
     As exchange rate stability is the primary concern,
                                                           operating throughout the country since then and
the NRB normally does not change (increase/
                                                           the number of money changers as at mid-June 2005
decrease) the intervention rate; it uses the middle rate
                                                           stood at 219.
of the prevailing published rate while purchasing the
                                                               The NRB issues two categories of licenses—one
foreign exchange from the commercial banks or
                                                           for Indian currency and another for convertible
selling it to them. However, it can (and has sometimes)
                                                           currencies. Both categories require the fulfillment of
used different rates, if it believes that the prevailing
                                                           the necessary procedures stipulated by the NRB. Over
exchange rate is unduly overvalued or undervalued.
                                                           and above the general procedures set forth by the
     Though the NRB does purchase/sell foreign
                                                           Bank, the money changers are required to deposit
exchange through intervention, it does not want get
                                                           Rs. 100,000 as guarantee in case of license for Indian
involved in such activity; rather it intends to meet the
                                                           rupees and Rs. 600,000 for convertible currencies to
requirement of the concerned bank through inter-
                                                           the NRB. Of the amount, at least 10 percent must
bank transactions. This implies that if a commercial
                                                           be in cash and the remaining 90 percent can be in the
bank requires foreign exchange, it should first try
                                                           form of bank guarantee. It is to be noted that a
satisfying its need from another commercial bank. It
                                                           license holder of convertible currency is not allowed
may approach the NRB, through FEDAN, only when
                                                           to sell the foreign currencies; only buying is permitted.
the requirement is not fulfilled through the inter-bank.
                                                           Such a money changer needs to surrender the foreign
As an association of the foreign exchange dealers,
                                                           currency to the bank, in which it had opened an
the FEDAN keeps the information of the foreign
                                                           account as per stipulation of the NRB. With respect
exchange position of all of its members. If the NRB
                                                           to the Indian currency, the moneychanger can both
entertains requests of individual banks, there may be
                                                           buy and sell the Indian rupee.
a possibility of commercial banks to approach the
                                                                                        FOREIGN EXCHANGE      321

Money Remitting Firms or Companies                         Import
    It is well known that the tendency of the Nepalese         Prior to the adoption of present open and liberal
going abroad for employment has been taking an             policy through the adoption of open general license
increasing trend in recent years. Initially, most of       (OGL) system, Nepal’s import trade was too much
them used to send their earnings to Nepal through          restrictive. Subsequent to the introduction of OGL
the unofficial channel owing to several factors            system, import of all the commodities except gold,
including the lack of knowledge about the banking          silver, precious stones, intoxicated drugs and
practices. They used to send their earning mainly          armaments, has been made open. The earlier
through the ‘hundi’ system. Some of the workers            restrictions imposed on import from countries other
used to send their savings with their friends and          than India has been lifted. Now, everyone can import
relatives that were returning to Nepal. Some, on the       unspecified quantity/amount of goods by opening
other hand, used to carry the money while returning        letter of credit (L/C). In the case of small imports,
back.                                                      opening of L/C is not even required. They can be
    Under such circumstances, there is every               imported through drafts/TTs. In this connection,
possibility that the fund would not reach the specified    immediately following the introduction of OGL
person in whose favor it was sent. Apart from this,        system, import of up to US $ 3000 could be made
it was difficult to estimate the inflows as such           through drafts/TTs. The amount has been raised to
remittances are not recorded in the statistics.            US $ 30,000 now. The foreign exchange required
Therefore, the NRB initiated efforts to channel such       for such import is made available easily through the
inflows through the official channel and started issuing   commercial banks.
license to the private sector. Currently, private sector       Regarding the import from India, although the
money transfer units are becoming more and more            normal mode of payment is in Indian rupee, which
active and encouraging Nepalese workers to remit           is freely convertible, some of the products can also
money through the official channel. By mid-June            be imported on payments of convertible currencies.
2005, the number of such units has reached to 23.          This system was introduced since 1993 in order to
One money-remitting company has been even                  facilitate the easy access to industrial raw materials.
carrying out such business by opening an office            Presently, there are 66 items that can be imported
abroad. In this connection the NRB has prescribed          under this system. Only the registered industries are
fairly easy license issuing procedures. A firm or          eligible for importing goods by opening L/C and
company willing to undertake money remitting               imports would be permitted only from the
business as an agent of a company abroad would             concerned manufacturing firm/company of India.
need to keep only Rs. 600,000 as in the case of
                                                           Foreign Currency Account
money changers. However, a bank guarantee
                                                               Export and tourism have been the traditional
equivalent to Rs. 5 million is required for opening an
                                                           sources of foreign exchange for Nepal. Of late, there
office abroad.
                                                           has been an increasing tendency for Nepalese to seek
    Because of the diversification of institutions, the
                                                           overseas employment and hence remittances from
remittances through the official channel have been
                                                           the workers have been emerging as one of the
increasing remarkably as shown by the data published
                                                           principal sources of the convertible currencies for
by the NRB.
                                                           the country. Prior to the adoption of liberalization
Other Reforms                                              policy, the foreign exchange earners were required
    After moving into the market determined                to surrender their earnings to a bank at the then
exchange rate system, the policy of providing the          prevailing exchange rate, which was not reflective
foreign exchange facilities has been changed               of the market. The commercial banks were required
accordingly. There have been substantial relaxations       to buy the foreign currency using the exchange rate
in the policy pertaining to the provision of foreign       fixed by the NRB. Under such an exchange rate
exchange. In the context of a liberal exchange rate        system, the value of national currency appeared to
system, the imposition of stringent measures as            be generally at an appreciated level. This tendency,
carried out during the fixed exchange rate regime is       aside from discouraging exports, also made the
not necessary.                                             foreign exchange earners feel that they were not
322    NEPAL RASTRA BANK IN FIFTY YEARS

obtaining the actual price of their earnings. This           Of the two categories, encouraging the first category
contributed to increase the tendency of either not           to bring in the foreign exchange earnings into Nepal
bringing in the foreign exchange to the country or           is not easy without convincing them of easy
exchanging them in the black market. The prevalence          withdrawal as well as the spending facilities.
of huge black market premium in those days would             Moreover, there is a practical difficulty to compel
be enough to substantiate this.                              them to bring in their foreign exchange earnings. Thus
    The foreign exchange earners may have felt               the criterion for withdrawal and spending from such
deprived of the actual price of their earnings even          account has been made fairly wide and easy. In case
under the present market determined exchange rate            of the second category, however, the criterion has
system as several complaints are often lodged from           been made relatively narrow because of the legal
the business community about cartelling by the               binding for them to bring the foreign exchange.
commercial banks while fixing the exchange rate.             Notwithstanding the relatively narrower criteria, they
Besides, the foreign exchange earners would incur            have benefited much from the system.
loss if they sold the foreign exchange at buying rate
                                                             Foreign Exchange Facility
and bought it at the selling rate.
                                                                 During the controlled regime no one was
    Though everyone was familiar with these issues
                                                             permitted to obtain foreign exchange without the
in the earlier days also, but due to the prevailing
                                                             approval of concerned authority. The situation has
economic policy and restrictions in the legal system,
                                                             changed remarkably in the recent years and this is
there was no provision to open foreign currencies
                                                             going to be relaxed more in the years to come. Now,
until the first amendment of the Foreign Exchange
                                                             the requirements of foreign exchange for any
Regulation Act 1962 in 1987. Only then the foreign
                                                             purpose can be obtained directly from the
exchange earners were permitted to open foreign
                                                             commercial banks. The present arrangements in this
exchange account in a bank in Nepal. In the beginning,
                                                             regard can be broadly divided into following:
accounts could be opened only in the US dollar and
                                                             a) Exchange facilities not requiring permission for
the Sterling Pound. Subsequently, the list of currencies
                                                                 unspecified amount of foreign exchange,
has been increased. Now, the foreign exchange
                                                             b) Exchange facilities not requiring permission for
account can be opened in all the currencies for which
                                                                 up to a certain specified limit, and
the buying and the selling rate are being fixed by the
                                                             c) Exchange facilities that can be acquired only after
NRB. Initially, such account could be opened only
                                                                 the permission.
up to 30 percent of the earnings. The proportion
                                                                 (a) Exchange facilities not requiring
has been gradually increased and now the foreign
                                                             permission for unspecified amount of foreign
exchange earners are allowed to keep all of their
                                                             exchange: Such unlimited foreign exchange facility
earnings by opening foreign currency account in a
                                                             is to be made available directly through commercial
bank. Moreover, while only the foreign nationals and
                                                             banks for the payment of import through letter of
institutions were eligible to open such account initially,
                                                             credit by any firm, company or industry registered
now the Nepalese nationals and institutions are also
                                                             under the existing rules and regulations. Lately, the
allowed to open such account.
                                                             foreign exchange required for the payment to
    Under the arrangement, four types of accounts
                                                             educational institutions abroad also does not require
(current, saving, call, and fixed) are allowed to be
                                                             permission from the NRB. The concerned
opened in any of the commercial banks in Nepal
                                                             commercial bank can provide such facilities provided
upon presentation of relevant documents specifying           the applicant has approached the bank with the
the sources of foreign exchange earnings. Eligible           documents from the institutions as well as
individuals, firms, entities or commercial banks need        recommendation from the Education and Sports
no permission from the NRB to open such accounts.            Ministry.
    The existing foreign exchange account can                    (b) Exchange facilities not requiring
broadly be divided into two categories: a) foreign           permission for up to a certain specified limit:
nationals and institutions and Nepalese nationals            Commercial banks are allowed to provide the foreign
having the source of foreign exchange earning, and           exchange facilities for certain purposes directly. But
b) exporters, hotels and travel/trekking agencies etc.       the maximum limit of such facility is fixed by the
                                                                                         FOREIGN EXCHANGE      323

NRB and it can be changed from time to time.                    A comparative study of the yearly movements
Currently, no permission is required for providing          of exchange rates and international reserve of two
the foreign exchange of up to US$ 1,000 for any             periods i.e. from 1960 to 1992 (the year when
purpose (except for capital account), if that amount        Nepalese rupee was made partially convertible in the
is for the payment to an institution abroad. Similarly,     current account) and from 1992 to 2004 shows that
since the requirement of opening of letter of credit        in the close regime the balance of payment used to
is not made compulsory for importing goods of up            be deteriorated frequently as shown by movements
to US $ 30,000 and can be imported under drafts/            in the international reserves of the country, forcing
TTs also, such payments can be made directly from           the authority to adjust (generally devalue the national
the commercial banks. Moreover, Nepalese citizens           currency) the exchange rate of domestic currency,
visiting countries other than India are allowed             sometimes in a huge magnitude.
exchange facilities not exceeding US$ 2,000 directly            Such a situation would not emerge in the
from the commercial banks against their passports           liberalized system; the market would automatically
once in a fiscal year. However, this restriction of         adjust the exchange rate. In this context, there is
receiving this facility once in a fiscal year may not       marked improvement in the standard deviation of
apply to the government officials or officials from         6.8 during the second period (in the liberalized era
public corporations.                                        even in the context of small sample, that is, where
    (c) Exchange facilities that can be acquired            the number of observations is 13) as opposed to
only after the per mission from the NRB:                    11.5 in the first period, having fairly large number
Permission of foreign exchange facilities for almost        of sample, that is, 33; the marked improvement in
all current transactions is granted if the applicants       the standard deviation in the liberalized era would
furnish relevant documents. The permission for the          support the hypothesis that exchange rate is the main
purpose of living expenses for the students pursuing        factor for the weakness of the overall foreign
education abroad, medical expenses, conventions,            exchange system. While the exchange rate was less
meeting etc. abroad is to be granted by the NRB             volatile during the second period, the rise in the
on the basis of documentary evidence. In other              convertible currencies’ reserve also supports the
words, anyone requiring foreign exchange for the            preference of liberal exchange rate system over the
above purpose and applies at the NRB with the               controlled one.
invoice from the concerned institutions will get the            Despite these achievements, there are several
permission if the demand is substantiated by the            issues that need to be taken into consideration.
valid documents.
                                                            The Exchange Rate System
    The NRB also readily issues exchange permission
                                                                The exchange rate of the Nepalese rupee has been
for some items of capital nature such as payment
                                                            pegged with the Indian rupee, the exchange rate for
for principal and interest of loans, dividend, technical
                                                            which is officially determined. On the other hand,
service fee, management fee and royalty, as per the
                                                            India is under the managed floating rate system. The
existing legal system.
                                                            value of Indian rupee is increasing in the recent years.
Issues Relating to Foreign Exchange System                  Its exchange rate vis-à-vis the US dollar has
    After the liberalization of exchange rate system        appreciated even remarkably because of the fall in
and subsequent relaxations in rules and regulations in      the US dollar rate driven by a dramatic rise in its
this regard, substantial improvements can be seen in        trade deficit. The Indian economy is performing well
the foreign exchange front, thus falsifying the             over the years and the prospect is expected to be
apprehension of adverse consequences of the                 better in the years to come, signaling even further
liberalization policy. The primary objective of the         appreciation of the Indian rupee.
foreign exchange policy is to maintain stability,               On the other hand, the situation of Nepal is just
particularly external sector stability. The stability of    the reverse owing to the deterioration in the law and
the exchange rate movement and build up of the              order situation of the country caused by the internal
international reserves over the years illustrate that the   insurgency. The economy has been growing by less
current foreign exchange policy of Nepal is rightly         than 3 percent. The conventional sources of foreign
shaped.                                                     exchange earning, that is, tourism is drying up and
324    NEPAL RASTRA BANK IN FIFTY YEARS

earning from exports is not likely to increase unless      constant monitoring of the exchange rate movement
the law and order situation is improved.                   as well as periodic revision in the parity. This is essential
Furthermore, foreign capital, including foreign aid,       not only from the economic perspective, but also
is also not expected to increase in the immediate          from the viewpoint of maintaining confidence by
future at least until the law and order situation in the   the Nepalese in the national currency. It is to be noted
country is restored. All of this would lead to exert       that the dual currency system was abolished after 1966
pressure in the balance of payments position, which        when the Nepalese currency was kept unchanged for
in turn would result in the depreciation of the rupee.     a while even after substantial devaluation of IC by
    However, given the exchange rate system, it is         India. Now, the circulation of IC seems to be
necessary for Nepal to adjust its exchange rate with       increasing again. Therefore, rather than keeping the
US dollar in line with the movement of IC/Dollar           exchange rate unchanged for a long period of time
rate in order to control the gap of the broken cross       and taking a pronounced devaluation or revaluation
rate. The NRB has been successful to maintain the          decision, it would be desirable to adjust the rate by
broken cross rate within limit, thanks to its practice     applying due caution to curb the likely speculative
of prompt response to commercial banks’ request            tendencies. Even in the present context, one cannot
for intervention.                                          rule out the possibility of speculative motives. The
    The exchange rate of Nepalese rupee vis-à-vis          timely revision in NC/IC rate is advisable even for
the Indian rupee has been fixed at Rs 1.60 per Indian      maintaining the Nepalese rupee competitive in terms
rupee. The parity was fixed on February 12, 1993,          of convertible currencies.
by revaluing the national currency by 3 percent (from
                                                           Capital Account Convertibility
NRs. 1.68 to NRs 1.60 per unit of IR) against the
                                                                This has been a widely debated issue in recent
Indian currency as the Indian economy was passing
                                                           times and also seems relevant in the present context.
through a difficult phase during that period, reducing
                                                           It is being contended that the external sector would
its foreign exchange reserve position to its lowest
                                                           perform even better if the capital account opened
level of about US$ 1 billion. Over the years, the Indian
                                                           up. The example cited is the improved performance
economy has undergone drastic changes, especially
                                                           observed after the opening of the current account.
with respect to the foreign exchange reserve position
                                                           This can be taken as a valid argument. However,
that has crossed US$ 140 billion. Even under such a
                                                           given the open border with India, liberalization of
situation Nepal has been able to keep the NC/IC
                                                           the Indian economy, and the country’s current fluid
exchange rate constant for over 12 years at the same
                                                           situation, one needs to think twice before making a
time not allowing cross rate differentials of more
                                                           suggestion for opening the capital account across the
than 2 percent. This has been possible due to the
                                                           board. It is true that Nepal’s balance of payments
continuous improvements in the balance of payments
                                                           position has been constantly in surplus for the last
and subsequent rise in the foreign exchange reserve
                                                           several years. But, one should not forget the declining
position of the country. Even the Indian currency
                                                           trend observed more recently. Even India, whose
reserve was increasing up to 2002. Thereafter, the
                                                           position is remarkably favorable, has not made its
IC reserve of the country started to take a downward
                                                           currency fully convertible, but is cautiously moving
trend and Nepal has now reached a position of
                                                           towards this direction.
purchasing the Indian rupee by spending convertible
                                                                Besides, the balance of payments position has
currencies. Though this situation has been brought
                                                           been in surplus mainly due to the emergence of a
about principally by the payment of POL products
                                                           relatively new source of foreign exchange, that is,
by the Nepal Oil Corporation in Indian currency as
                                                           remittances from the workers employed abroad. A
opposed to the dollar payment earlier, the sharp drop      look at the balance of payments table published in
in the Indian currency reserves can also be ascribed       the NRB’s Quarterly Economic Bulletin shows that the
to the implicit rise in the value of the Nepalese rupee    surplus has been largely driven by the remittances.
vis-à-vis the Indian rupee.                                Inflows from other sources have not been that
    Given the open border together with the cultural       substantial. The remittance cannot be considered as
and economic proximity, it is not advisable to float       a sustainable source of foreign exchange as it depends
the Indian currency. However, it is crucial to undertake   solely at the mercy of a country providing
                                                                                         FOREIGN EXCHANGE       325

employment to the foreign workers. A country can           capital account. It is not pertinent to prescribe the
change the policy relating to employment of foreign        opening up of capital account under the present two
workers, thus affecting the inflows. No international      distinct exchange rate systems for IC and convertible
forum, including the World Trade Organization, is          currencies.
likely to interfere in this matter. For example if             Though there has not been complete liberalization
Malaysia, one of the major countries providing             and there exist certain weaknesses which call for due
employment to Nepalese, changes the policy and             consideration, viewed from the present state of
adopted a stand of not employing Nepalese worker,          liberalization in this sector—from the exchange rate
the remittance inflow would be severally affected.         determination system to relaxation in rules and
    Thus, opening the capital account without              regulation for providing foreign exchange facilities—
analyzing all the relevant issues may push the economy     it can be said that reform initiated in this sector,
into jeopardy. Every country can take lessons from         particularly after the introduction of convertibility
the East Asian crisis. Had the crisis-affected countries   of Nepalese rupee in 1992, has been far ahead of
adopted a fixed exchange rate policy or put certain        other sectors of the economy. While the shift from
regulations for foreign investment, particularly in the    an officially determined exchange rate regime to a
inflow of hot money, they would not have to face           market determined one is the landmark development
the crisis of that magnitude. Countries adopting a         in this direction, equally significant is the introduction
cautious stand, such as China and India, were insulated    of the open general license system. Besides, incessant
from the crisis. Hence, prescribing the opening up         relaxations in rules and regulations regarding foreign
of capital account across the board at one go is not       exchange transactions including the exchange facilities
advisable, at least until the restoration of normalcy      to be provided to general public, foreigners as well
in the country.                                            as to the foreign investors have contributed much.
    The foregoing issues have been deliberated not             Capital account has not been opened yet and may
with the intention of sticking with the present policy.    take some more years. There is still the requirement
Eventually, Nepal should also go for opening up of         of permission from the NRB for obtaining exchange
the capital account. For the time being however, the       facilities even for some of the current transactions.
country should adopt a gradual approach. Initially,        However, in view of the constant efforts of the NRB
specifying a certain limit can open some of the            to undertake reforms, it can be fairly said that the
transactions of capital nature.                            foreign exchange system of Nepal would be more
                                                           open and liberal in the years to come.
Other
    Though there have been substantial relaxations in      Endnotes
the trade regime as well as in the provision relating         1
                                                                 Details are given in NRB (1996), p. 95
to foreign exchange, there are still many regulations         2
                                                                 Ibid, p. 96
that can be relaxed soon. These include provisions            3
                                                                The currencies included US $, Pound Sterling,
such as providing passport facilities only once in a       Swiss Franc, German Mark (DM), Japanese Yen,
year, requirement of NRB permission even to take           Canadian $, French Franc, Swedish Kroner,
loans from abroad, requirement of NRB permission           Netherland Guilder, Austrian Schilling, Italian Lira,
for repatriation etc.                                      Australian $, Pakistani Rupee, Belgian Franc,
                                                           Burmese Kyatt, Malaysian Ringgit, and Indian
Conclusions                                                Rupee Later, the Malaysian Ringgit was removed
    Even after more than a decade of the reform            from the list.
process, Nepal’s foreign exchange system cannot be            4
                                                                NRB (1996), p. 98.
termed as a well-managed and fully liberal one. While         5
                                                                See Ibid and Table 3 for details.
capital account has not been fully liberalized yet,           6
                                                                For detail, see NRB (1996), pp. 107-112.
certain current account transactions still require NRB´s   References
permission. More importantly, even the exchange rate       Adhikary, Ram Prasad. 1996. “Nepal´s Foreign
system, the backbone of foreign exchange system,             Exchange Rate Policy and Its Foreign Trade.”
requires improvement prior to the opening of the             Mirmire, The Bankers’ Club.
326    NEPAL RASTRA BANK IN FIFTY YEARS

Legal Book Managing Committee, His Majesty´s                  NRB. 2000. A Collection of the Circulars Issued by the
   Government of Nepal. Various years:                          Foreign Exchange Management Department of the Nepal
   a. Nepal Rastra Bank, Act 1955 (with amendments).            Rastra Bank (Circular No.249 to 301). Kathmandu:
   b. Increase in the Circulation of Nepalese Currency Act,     NRB.
       1957.                                                  NRB. Various Issues. Circulars Issued by the Foreign
   c. Control of the Foreign Exchange Transaction Act,          Exchange Management Department. Kathmandu:
       1959.                                                    NRB.
   d. Foreign Exchange (Regulation) Act, 1962 (with           NRB. 1996. 40 Years of the Nepal Rastra Bank 1956-
                                                                1996. Kathmandu: NRB.
       amendments).
                                                              NRB. 1981. 25 Years of the Nepal Rastra Bank (1956-
   e. Nepal Rastra Bank Act, 2002.
                                                                1981) (in Nepali). Kathmandu: NRB.
Manandhar, K.B. 1996. “Foreign Exchange Policy
                                                              NRB. 1971. An Introduction to the Nepal Rastra Bank
   in Nepal.” Arunodaya                                         (in Nepali). NRB: Kathmandu.
Nepal Rastra Bank (NRB). 2004. Monetary Policy for            NRB. Various Issues. Quarterly Economic Bulletin.
   FY 2004/05. Kathmandu: NRB.                                  Kathmandu: NRB.
NRB. 2003. Monetar y Policy for FY 2003/04.                   NRB. Various Issues. Economic Report. Kathmandu:
   Kathmandu: NRB.                                              NRB.
NRB. 2002. Monetar y Policy for FY 2002/03.                   NRB. Various Issues. Annual Report. Kathmandu:
   Kathmandu: NRB.                                              NRB.
                                                                                                  INFLATION    327




                                              Inflation
                                           Ravindra Pd. Pandey
                                          Director, Research Department
Introduction                                                             affect the demand for money directly in
    Inflation is “a process of continuously                              a manner over and above their indirect
rising prices or equivalently of a                                       influence via nominal interest rates.
continuously falling value of money”                                           In the recent years, many
(Laidler and Parkin,1975). The definition                                economists and central bankers have
implies that a rise in the price of individual                           been advocating and adopting price
commodities is not inflationary if offset                                stability as the sole objective of monetary
by falls in other prices. A sustained rise in                            policy in order to promote economic
the general price level means that a given                               stability and economic growth. With the
sum of money will buy a smaller quantity                                 objective of price stability, inflation
of goods: hence the alternative characterisation of        targeting has been considered as one of the best
inflation as a continuous decline in the purchasing        monetary frameworks in conducting monetary policy.
power of money. The value of durable goods                 In fact, this policy framework is based on the classical
producers or consumers’ - however, remains roughly         concept of direct relationship between money and
constant as the prices of goods rise along with general    price. Among other objectives, price stability has been
price index. If these goods also serve as alternative      considered as the most achievable objective of
assets to money, an increase in the expected rate of       monetary policy. Hence, the level and dynamics of
inflation would cause a shift out of money and bonds       price become unavoidable pre-requisites for any
into consumer durables. A number of studies based          economic analysis. The behaviour of the economy
on country-specific as well as cross-country data          in real term can be judged only on the basis of the
provide evidence to support this. These studies in         movements of prices and without actually getting a
general show that variations in the expected inflation     feel of the level of the price it becomes hard to
rate, explain the variations in the proportions of a       judge the performance of economy in real terms.
country’s assets held in liquid form (Laidler,1985).       Since the price stability is a main objective of
Many economists would also regard the expected             monetary policy, observations of price movement
rate of inflation as an important determinant of the       and identification of determinants of inflation are
opportunity cost of holding money. While                   vital for both monetary policy formulation and its
theoretically one might expect its influence to be         implementation. It is widely accepted that economies
reflected in the nominal rates of interests usually        perform better in terms of growth, employment
included in the demand for money functions, the            and living standard in a low inflation environment.
evidence does suggest that expected inflation rates        The low inflation helps maintain macroeconomic
328    NEPAL RASTRA BANK IN FIFTY YEARS

stability and supports proper allocation of resources           It is to be noted that the two main indexes used
in the economy. It also keeps the purchasing power          to compute inflation, the GDP deflator and the CPI,
of money stable ultimately helping in containing the        accordingly differ in behaviour from time to time.
spreading of poverty in the economy.                        For example at times when the price of imported
     If price implies the purchasing power of money         oil rises rapidly, the CPI is likely to rise faster than the
on the one hand, it also indicates value of goods and       deflator. In Nepal, CPI is mostly used to analyse the
services on the other. People have to pay the price         inflationary situation in the economy.
of goods and services at the time of consumption.               This essay is organized as below. Section two
In fact, nothing is free in life. Price is practically      covers the history of price collection in Nepal. Data
measured and expressed in monetary term. In the             and methodology in the analysis of inflation is given
market economy, the interaction between demand              in section three followed by the presentation of price
for and supply of any commodity determines the              movement in Nepal on decade basis in section four.
price of that commodity. There are various sorts of         Section five explains the composition and structure
goods and services with different prices and these          of CPI in Nepal, while review of various theories
prices change in the economy. Because of this               of inflation is done in section six. Section seven covers
situation, there exists a practice of constructing price    the econometric analysis of the determinants of
index to measure the general price level in the             inflation in Nepal, whereas section eight discusses
economy. Some examples of price indexes are: GDP            stationarity and co-integration test. The second last
deflator, Consumer Price Index (CPI), Wholesale             section deals with inflation controlling measures in
Price Index (WPI), etc.11                                   Nepal and finally, the last section concludes the essay.
     The GDP deflator is the ratio of nominal GDP
                                                            History of Price Collection
in a given year to real GDP of that year. The deflator
                                                                The history of price collection in Nepal can be
measures the change in prices that has occurred
                                                            traced back to 1902 when “Gorkhapatra” had begun
between the base year and the current year. Since the
                                                            to collect and publish retail prices of a few
GDP deflator is based on a calculation involving all
                                                            commodities (NRB, 1981). Since 1956, the
the goods produced in the economy, it is a widely
                                                            Kathmandu Municipality Office started publishing
based price index that is frequently used to measure
                                                            retail prices of consumers’ goods in its monthly
inflation.
                                                            magazine “Jana Chetana”. However, these attempts
     The consumer price index (CPI) measures the cost
                                                            could not last for a long period, as such in 1962, His
of buying a fixed basket of goods and services
                                                            Majesty’s Government, the Central Bureau of Statistics
representative of the purchases of urban consumers.
                                                            (CBS) began collecting prices of selected consumers’
The CPI differs from the GDP deflator in the
                                                            goods in the Kathmandu Valley.
following main ways:
                                                                Realizing the importance of price statistics, Nepal
(i) The deflator measures the prices of a much wider
                                                            Rastra Bank ( NRB) began collecting prices of
     group of goods than the CPI does.
                                                            essential consumers’ goods in a systematic way since
(ii) The CPI measures the cost of a given basket of
                                                            its establishment in BS 2013 (1956). Initially, NRB
     goods, which is the same from year to year. While
                                                            collected prices of 15 consumer goods in a
     the basket of goods included in the GDP deflator,
                                                            fortnightly basis. The number of consumer goods
     however differs from year to year, depending
                                                            were gradually increased to 31 in 1960 and then to
     what is produced in the economy in each year.
                                                            46 in 1965. In 1957, NRB started to construct the
     Any change in price affects different sectors of
                                                            un-weighted price index for Kathmandu and
the economy. Inflation, i.e., increase in price level, is
                                                            published it on a regular basis. Later in 1962, NRB
considered as an economic evil because it not only
                                                            brought forth the un-weighted price index for the
distorts prices but also erodes savings, discourages        Terai region and a year later in 1963, it was extended
investment, stimulates capital flight, inhibits growth,     to the Hilly region as well. In the mean time, since
makes economic planning a nightmare and in its              1962/63 CBS had started to construct and publish
extreme form, evokes social and political unrest            the weighted consumer price index for Kathmandu;
(Debelle et al, 1998). Such is the reason why price         however this process could continue only till 1969/
stability is desired by many in the economy.                70.
                                                                                                  INFLATION    329

    Ultimately to arrive at the weighted price index      influencing the price level in Nepal. As far as the
at the national level, Nepal Rastra Bank had no choice    empirical study is concerned, the sample has been
but to launch a nation wide household budget survey       taken for the period 1972/73 to 2003/04 because
(HBS) and then determine the weighting factors. The       of the availability of the weighted national consumer
first of such surveys was launched in the year 1972/      price index for that period only. It has been observed
73 and thereafter the second and the third surveys        that the Price level in Nepal has been significantly
followed in approximately a gap of ten years in           influenced by money supply, Indian price, exchange
1983/84 and 1995/96 respectively. The second              rate, and supply situation of food grains.
survey of 1983/84 was a multi-purpose household
                                                          Price Movements in Nepal
budget survey designed also to obtain the key
                                                              It is a universal fact that a higher rate of inflation
macroeconomic indicators of the country. The fourth
                                                          brings about volatility and ultimately paves the way
of such surveys is on the pipeline, scheduled to be
                                                          for distortions in the optimum allocation of resources
conducted starting the next fiscal year 2005/06.
                                                          in the economy. It is likely to induce inflationary
    After the launching of the first HBS, there has
                                                          expectations thereby encouraging distortion in the
been a continuous flow of data on consumer price
                                                          savings and investment. As such is the case, inflation
index, the weights of which are constantly being
                                                          in Nepal has remained the central concern of all the
updated and the consumption basket being revised
                                                          issues pertinent to economic management. All the
with the help of household budget surveys. The
                                                          efforts made by the Government in the past could
current weights of the consumer price index is based
                                                          simply not materialise to the desired level. In the span
on the third HBS conducted in 1995/96.
                                                          of the last 33 years after NRB started producing
    In addition to Consumer Price Index, NRB has
                                                          National weighted urban CPI, the annual rate of
also begun to publish the Wholesale Price Index (WPI)
                                                          inflation averaged at 8.9 percent. It reached to a
since 2000/01. This has indeed added new dimension
                                                          record level of 21.1 percent in 1991/1992 reflecting
in looking at the price movement in Nepal, thereby
                                                          as one of the major hurdles in the pursuit of stable
broadening the horizon and the scope in analysing
                                                          and self-sustained economic growth of the nation.
the movement of the price in the country.
                                                              To give an overall glimpse over the past fifty years,
Data and Methodology                                      the analysis of the price movement in Nepal has
   Although the time series data on price in Nepal        been carried out on a decade basis. Obviously, during
does not cover a long period, the observations of         the fifties, price movements were not found to be
price movements show rather a unique feature. Prior       uniform. The available statistics indicated that the
to 1972/73, as the weighted consumer price index          change in price was extremely severe in 1958/59 with
was not available at the national level, the available    the average inflation reaching a double digit at 11.0
information on price has been used as a proxy to          percent due mainly to the volatility in the exchange
analyse its movement for the period 1956/57 to            rate of Nepalese rupees vis-a-vis Indian rupees. In
1971/72.                                                  1960, there was the unification of the currency thereby
   For the period 1956/57 to 1961/92, un- weighted        making the Nepalese rupees the sole medium of
price index for Kathmandu computed by NRB has             exchange. The Nepal Rastra Bank during this time
been used whereas, data series on weighted consumer       was also successful in fixing the exchange rate of
price index for Kathmandu computed by the CBS             Nepalese rupees vis-a-vis the Indian rupees. As a result
for the period 1962/63 to1971/72 has been used as         of this, the changes in the price in 1960/61 was
a proxy for the national level and for the period after   marginal.
that, the availability of the time series on weighted
                                                          In 1960s
urban national consumer price index produced by
                                                             An analysis of the price movements during the
NRB has made it imperative for its use.
   Price movement has been observed based on the          sixties 2 shows that the annual rate of price rise
available statistics with some important explanation      measured in terms of the Consumer Price Index
for substantial movement of price. However,               (CPI) averaged at 6.2 percent. It is interesting to note
empirical study has been carried to identify the          that during this period, three of the fiscal years viz.,
determinants that are statistically significant in        1964/65, 1965/66 and 1969/70 witnessed double
330        NEPAL RASTRA BANK IN FIFTY YEARS

digits inflation at 11.2 percent, 14.2 percent and 10.7        pressure in the early years of the of seventies.3 Nepal
percent respectively. The price dynamics during the            had also been hit heavily with inflation at double digit
mid sixties and also towards the end depicts an                during the period 1972/73 to 1974/75 due mainly
alarming trend. The prices of food articles for all            to the rise in the prices of petroleum products.
Nepal showed a substantial upward movement and                 Monetary expansion during these years had also
recorded the highest change in 1964/65. This                   contributed to the upward thrust in the inflation of
unprecedented rise in the price particularly of the            the Kingdom. The price rise was as high as 11.0
food articles was attributable to the adverse weather          percent to 18.8 percent during these years. To curb
situation causing a drastic fall in the production of          with the situation, His Majesty’s Government had
food grains in the kingdom. The situation was also             introduced a 10 points inflation control measure to
not favourable in India either: as such, the supply            contain the inflation, which had then rocketed during
shortage due to the poor performance of the                    1972/73 to 1974/75.
agriculture sector in the country in conjunction with              However, a good harvest as well as the price
the rise in the import price induced the CPI to move           control measure taken in India following the
up during 1964/65 to 1965/66. In addition to this,             declaration of emergency in conjunction with the
monetary expansion had also contributed to such a              increase in the production of food grain together
rise in price during these years. However, the                 with monetary tightening back at home had eased
succeeding year viz. FY 1966/67 witnessed only a               the pressure on the price front ultimately leading to
marginal rise in the price level and a year later in 1967/     the negative growth of 0.6 percent in the inflation
68 the price poised a negative growth. The                     rate in FY 1975/76. The price index of food and
contributory factor for the fall in the prices was the         beverage group during this period registered a decline
appreciation of Nepalese currency vis-à-vis Indian             of 3.9 percent.
currency in May 1966. Thereafter in December 1967,
the Nepalese currency was devalued vis-a-vis the
Indian currency by 24.78 percent thereby leading the                               Inflation in 1970s
                                                                  20
prices of most commodities, including that of the
                                                                  15
food articles to go up. During this time, both the
custom and excise duties were increased heavily and               10

as a result of excessive credit disbursed to the public            5
sector and a rise in the net foreign asset, money supply           0
had gone up. In addition to all these, the prices of                    1971 1972 1973 1974 1975 1976 1977 1978 1979 1980
                                                                   -5
non food items in India had also gone up. All these
factors cumulated to exhibit an upward thrust in the
prices to register at double digit (10.7 percent ) in              The movements in the prices in the individual years
the last year of the sixties.                                  during the review period were not uniform. The
                                                               changes in the prices of food and beverages were
                       Inflation in 1960s                      observed to be more erratic that that of non- food
    16
    14
                                                               and services implying a direct relationship of food
    12                                                         grains production in the country and their import
    10                                                         prices from India. Although some pressure had
      8
      6
                                                               started to build up in the prices both in the country
      4                                                        and neighbouring India, after the Emergency in India
      2
                                                               was lifted, a good harvest of the cereal and other
      0
      -2   1961 1962 1963 1964 1965 1966 1967 1968 1969 1970   food grains helped contain inflation at a lower single
                                                               digit of 2.6 percent in 1976/77.
                                                                   The production of food grains in 1977/78 had
In 1970s                                                       recorded a decline. In April 1977, the Nepalese rupees
   As a result of the world oil crises, major parts            was devalued with the Indian currency by 4.3 percent
of the globe had experienced a high inflationary               and re-valued with the US dollar in order to diversify
                                                                                               INFLATION    331

imports from India to third countries. The impact         1979/80 and 3.0 percent in 1982/83. On the other
was then felt by a sudden unprecedented jump in           hand, monetary expansion, due to a higher level of
the price level by 11.4 percent in 1977/78. It was        deficit financing, was steady which had an adverse
also observed that the year 1976/77 saw a substantial     implication on the prices as well as on the balance of
increase of 27.6 percent in the money supply as well      payments in the beginning of 1980s. In September19,
as a significant increase in the indirect taxes by HMG.   1981 and December 17, 1982, Nepalese rupee was
Also, the central excise duty in India was increased in   devalued by 9.1 percent and 7.7 percent respectively
1978. All these factors have made a significant           vis-à-vis US dollar in order to gain control of the
contribution in exerting an upward pressure in the        BOP crisis. Such successive devaluation had also
price in 1977/78.                                         obviously contributed significantly in flaring up of
    In order to combat the increasing level of price      the inflation.
in the country, HMG had revised custom and excise             A number of anti-inflationary policy measures
duty thereby containing the inflation at a single digit   with regard to monetary management were taken
in 1978/79; however the shortfall in the production       during this period. The two large state owned
of food grains and an upward revision in the prices       commercial banks were allowed to open branches
of petroleum products in 1979/80 contributed to           so as to mobilize savings and also mop up the
an upsurge in the price level again registering the       excess liquidity in the economy. The commercial
inflation at double digit of 11.0 percent in the FY       banks were directed to maintain 25 percent of
1979/80.                                                  total deposit liabilities in liquid assets while a
    The average national inflation in the seventies is    compulsory cash reserve ratio of 4 percent of
recorded at 7.9 percent compared to 6.2 percent in        the total deposits in their safe vaults and 5 percent
the sixties.                                              of total deposits with the Nepal Rastra Bank
                                                          effective July16, 1981. The central bank also
In 1980s
                                                          instructed the commercial banks to maintain a 3:1
    The 1980s witnessed an average inflation rate of
                                                          ratio between borrowings and capital fund
10.7 percent (Table 1), which was higher than in the
                                                          effective from the fiscal year 1981/82. A number
previous decades. The analysis of the annual price
                                                          of consecutive changes in the interest rate structure
movements in this decade revealed some
                                                          were effected on June 15,1982 and August 17, 1982
unprecedented rise in inflation in the fiscal years
                                                          to control the domestic price level, correct the ever
1980/81 (13.6 percent), 1981/82 ( 10.6 percent),
                                                          widening trade deficit and maintain an appropriate
1982/83 (14.0 percent), 1985/86 ( 15.9 percent),
                                                          level of liquidity. The commercial banks were also
1986/87 ( 13.4 percent), and 1987/ 88 ( 10.9 percent).
                                                          directed to provide loans against the government’s
This reflects that the country was facing double digit
                                                          Development Bonds for a maximum period of
inflation for more than half the period between 1980-
                                                          one year at a rate of 1.5 percent higher than the
1990. Various factors contributed to the upsurge in
                                                          rate specified in the Bonds.
the price movement on Nepal. The higher rate of
                                                              To foster healthy competition among banks,
inflation recorded during these periods may be
                                                          commercial banks were granted autonomy to offer
attributed among other things to the rise in prices of
                                                          1.5 percent (savings deposits) and 1.0 percent (time
food and beverages group, higher inflation rates in
                                                          deposits) above the prevailing rates of interest
India, the lagged impact of the rise in the price of
                                                          effective November 16, 1983. In addition, measures
petroleum in Nepal in 1979/80, increase in the cost
                                                          were also adopted to enable commercial banks to
of production due to the rise in the fertilizer prices
                                                          maintain a credit-deposit ratio of 75 percent by mid-
and expansionary fiscal policy of the government
                                                          July 1985 (Mathema, 1995)
which registered a growth of about 30 percent in
                                                              As a result of the improvement in the domestic
government expenditure in 1981/82 and 1982/83
                                                          agricultural production (28 percent), as well as price
each4. The production of food grains had declined
by 12 to 16 percent between 1979/80 and 1982/83           situation both in Nepal and India and in pursuance
owing to a severe drought experienced both in Nepal       with the above-mentioned anti-inflationary measures,
and the bordering areas of India. Hence, the real         inflation dropped to single a digit at 6.3 percent in
GDP had witnessed a decline of 2.3 percent in             1983/84 and 4.0 percent in 1984/85.
332        NEPAL RASTRA BANK IN FIFTY YEARS

                                                               in 1985/86, which was supported by a stand-by
                      Inflation in 1980s                       arrangement with the International Monetary Fund.
      20                                                       The programme brought significant stabilisation gains
      15                                                       in the field of external current account deficit and
                                                               the overall balance of payments, but not in the price
      10
                                                               sector. In pursuit of redressing structural constraints
      5
                                                               to growth and maintaining inflation rate at a desirable
      0                                                        level and strengthening the external current account
           1981 1982 1983 1984 1985 1986 1987 1988 1989 1990   position over the medium ter m, the country
                                                               embarked on a three–year Structural Adjustment
                                                               Programme (1987/88-1989/90). The introduction
    However, the price situation could not remain              of programme budgeting, enhancing of the private
comfortable for a very long period. The inflationary           sector participation in industrialization,
pressure was again felt tremendously high during the           implementation of liberal export promotion policy
first three years of the second half of the eighties.          and the financial policy with the intention to keep
The fiscal years 1985/86, 1986/87 and 1987/88                  bank credit expansion within desirable limit were
witnessed a double-digit inflation at 15.9 percent, 13.4       some of the strategies adopted under the SAP
percent and 10.9 percent respectively with FY 1985/            In 1990s
86 facing the highest inflationary impact in the decade.           The nineties observed the speeding up of the
In spite of the increase in food grains production             economic liberalisation process. This decade also
and improvement in the price situation in India, the           experienced a higher-level inflation due mainly to the
devaluation of Nepalese rupee vis–a-vis the US dollar          structural changes in the economy. Average inflation
by 14.7 percent on November 30, 1985 was the main              stood at 9.6 percent during the 1990s (Table 1).
contributing factor to this higher rate of inflation.          Although the amicable resolution of the 15 month
Following the devaluation, electricity tariff was raised       long trade and transit dispute with India towards the
by 22 percent and fertilizer prices were raised ranging        end of 1989/90 eased the supply situation, the
between 20 to 33.5 percent. These factors had a                outbreak of the gulf war in August 1990, slowing
negative effect both on the cost of production of              down of the agricultural production (6.7 percent in
the domestic goods as well as on the prices of the             1990/91) combined with a relatively higher growth
imported goods.                                                of the aggregate WPI of India induced an upward
    The above factors are seen to have had a                   pressure on CPI to remain at 9.7 percent in 1990/
subsequent lag effects in the later two years of the           91.
decade. Although inflationary pressure moderated                   Although the average change in the National
to some extent during the last two years, it remained          Urban Consumer Price Index remained at a level
at a level higher than 8 percent. The last two years of        below 10 percent in most of the years in 1990s, the
1980s were also badly hit by the trade and transit             FY 1991/92 witnessed an inflation of 21.1 percent,
impasse with India beginning on March 23, 1989.                the highest ever recorded in the Nepalese context.
Although this impasse terminated in June 1990, it had          While looking at the regional distribution of inflation
a wide-ranging impact in Nepal’s economic                      rate in the review year, it is seen that Terai experienced
development, affecting adversely on the overall                the highest rate at 21.5 percent, followed by
growth rate, creating supply constraints due to heavy          Kathmandu at 20.8 percent and the Hills at 19.7
rationing of petroleum products and pushing up the             percent. Commodity wise, the inflationary thrust lied
prices of imported goods. A relatively better                  on the food and beverages group rather than in the
performance of the agricultural production could not           non-food and services. The index for the food and
fully nullify the negative impact created by the trade         beverages shot up by a whopping 24. 4 percent,
and transit deadlock with India, although it helped in         while that for the non food and services group went
bringing down the inflation level to a single digit.           up only by 15 percent. The higher rise in food and
    In order to redress the situation, the government          beverages index was mainly due to the steep rise in
embarked on an economic stabilization programme                the index of rice, the staple food of the Nepalese
                                                                                                     INFLATION     333

people and spices which were ultimately imported             economy lay ahead. Many reform measures were
from India.                                                  enhanced in order to maintain macroeconomic
    Many other factors were also responsible for such        stability together with bringing out the structural
an unprecedented rate of inflation in 1991/92. One           changes in the economy. Among others, containment
of the important factors was the devaluation of              of the monetary expansion within the manageable
Nepalese rupees vis-à-vis US dollar and other                limit, thus making it consistent with the real sector
convertible currencies by 20.9 percent towards the           growth and inflation was one of them. Open market
end of the FY 1990/91, following the policy of the           operation was introduced as an indirect tool to
convertibility in the current account, which pushed          control monetary aggregates within the desirable limit.
up the import prices of raw materials, fuels, fertilizers,   Major steps were also initiated in the financial sector
construction materials, daily consumer goods, etc.           policy reforms. Liberal policies were also adopted
Along with the devaluation, the government also              in sectors like the public enterprises, industry, foreign
adjusted upwards the administered prices of goods            investment and technology as well as trade and
and services like milk, petroleum products, education        foreign exchange. Prudential fiscal policy was
fees, telephone and electricity charges (IDS, 1994), in      adopted to contain the growing budget deficit by
line with the market based liberalisation policy. The        strengthening the revenue administration, and
higher rate of inflation in India (13.5 percent              prioritizing and restraining government expenditure.
measured by WPI) due to the balance of payments                  Inflation was relatively stable, at around 8 percent
crisis and the resultant devaluation of the Indian           between 1992/93 and 1997/98. The economic
currency also assisted in raising the prices of the          liberalization policies taken up by the government in
imported goods from India. Moreover, shortages               the various macroeconomic sectors since 1990 has
in the supply of essential food grains were also             been instrumental in containing the rate of inflation
experienced because of the shortfall in production           within a single digit in this period. Entering into ESAF
during the year in Nepal. In addition, the perpetually       (Enhanced Structural Adjustment Facility) in 1992/
long expansionary fiscal policy of the government            93 further assisted in achieving significant progress
in the past continued to put pressure on the monetary        in macroeconomic situation including the
liquidity that fanned the inflationary fire from the         containment of inflation (Mathema, 1995).
demand side. Increase in money supply also fuelled           Moreover, considerable improvement in agriculture
the inflation from the demand side as well. During           and non-agriculture production, reduction in tariff
the year, narrow money (M1) went up by 19.5 percent          rates, control in deficit financing, and relative stability
compared to an increase of 14.5 percent in the               in exchange rates also contributed in maintaining the
preceding year.                                              inflation at that level. However after six years of
                                                             gaining stability, inflation soared to 11.4 percent in
                                                             1998/99 due mainly to the surge in prices of food
                   Inflation in 1990s                        and beverage group as a result of a shortfall in the
   25
                                                             supply of cereals, vegetables, pulses and spices.
   20
                                                             Monetary expansion (M1) of 17.4 percent in 1997/
   15                                                        98 also contributed in fuelling up the price in the
   10                                                        following year. However, inflation came down to
    5                                                        3.5 percent in the 1999/00 owing mainly to the rapid
    0                                                        deceleration in the price index of food and beverage
        1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
                                                             group attributing to the good harvest of cereal
                                                             production as a result of favourable weather
                                                             condition.
    This period was crucial for the Nepalese economy
from various points of view. Along with the                  2000 Onwards
restoration of democracy in 1990 and the                        From the very beginning of the twenty-first
assumption of the political power by the popularly           century, inflation has been contained at the desirable
elected government in 1991, Nepal entered into               level. Many countries around the Globe also
the era where difficult challenges in rebuilding the         experienced low level of inflation in most parts of
334    NEPAL RASTRA BANK IN FIFTY YEARS

the 1990s and the beginning of 2000s. Inflation in                There are 10 different subgroups in the Food and
Nepal stood at 2.4 percent in 2000/01, 2.9 percent           Beverages Group and 7 different subgroups in the
in 2001/02, 4.8 percent in 2002/03 and 4.0 percent           Non-food and Services group
in 2003/04. A good supply situation and a favourable              The current weighting factors have been derived
price situation in India in conjunction with a good          from the Third Household Budget Survey (HBS)
harvest both in Nepal and neighbouring India as a            conducted in 1995/96 (Appendix 1). It has been
result of a favourable weather condition for both            noticed that the weights have been gradually shifting
the cereal and cash crops as well as vegetables and          with time since the first survey conducted in 1973/
fruits is mainly attributed in containing inflation at a     74, gradually gearing towards non-food and services
level lower than 5 percent during the first four years       groups reflecting the changing nature of the
of the 2000’s. However, the hike in the prices of            consumption pattern being drifted away from the
petroleum products by an average of 35.7 and an              food items. However, the food and beverages group
upward revision in the VAT rate by 3 percent during          still occupies 53.2 percent of the weight.
the first half of the FY 2004/05, is expected to exert
an upward thrust on the consumption basket raising            Table 2
the inflationary pressure slightly above the projected        Structure and Performance of CPI During
level of 4.3 percent in 2004/05.                              1973/74 to 2003/04
                                                                                              Mean in    Standard
 Table 1                                                                                      Percent    Deviation
 Price Dynamics (Percentage Change)                           Overall CPI                          9.0         5.1
                 Food and      Non-food &                     Food & Beverage                      9.0         7.0
                 Beverage         Services                    Grains and Cereal products           8.0        10.5
                                                                Rice and Rice Products             8.1        11.0
 Period            Group            Group       Overall
                                                              Pulses                              10.3        11.7
 1960s                 4.8*             NA           6.2      Vegetables and Fruits               10.2        10.0
 1970s                  8.0              7.7         7.9      Spices                              11.4        16.3
 1980s                 11.0             10.2        10.7      Meat, Fish and Eggs                 10.1         5.5
 1990s                  9.9              9.1         9.6      Milk and Milk Products               9.5         5.6
                                                              Oil and Ghee                        10.0        15.5
 2000 onward**          2.3              5.0         3.5
                                                              Sugar and Related products           7.3        14.2
 * It is an average of last five years (1965/66 to            Beverage                             8.7         7.0
    1969/70).                                                 Restaurant Meals                    11.1         8.5
 ** First four years only.                                    Non-Food & Services                  8.9         3.3
                                                              Cloth, clothing & Sewing Services    7.3         3.7
                                                                Cloths                             6.4         4.6
Composition and Structure of the CPI in                         Clothing                           7.8         4.0
                                                              Footwear                             6.9         4.5
Nepal                                                         Housing                              8.6         4.4
     The National Urban Consumer Price Index is                 Fuel, Light and Water             11.8         7.4
constructed and published on a monthly basis. For             Transport and Communication          9.1         5.7
food items, prices are collected every week; while in         Medical and Personal Care            7.8         4.0
                                                              Education, Reading and Recreation    9.4         5.5
a number of other cases, as with household materials,         Tobacco and Related Products         7.5         5.3
health services, personal cares, etc., data are collected
less frequently, either on a monthly, quarterly, half            During 1973/74 to 2003/04, food and beverage
yearly or yearly basis. The number of items in the           groups remained highly volatile compared to non-
consumption basket varies according to different             food and service groups. The standard deviation of
regions. The CPI basket for Kathmandu Valley                 the former group stood at 7.0 while that of latter
consists of 301 items, while it includes 282 and 262         group stood at 3.3 (Table 2). Within the food and
items in the case of the Hills and the Terai respectively.   beverage group, prices of grains and cereal products,
The CPI component indices are publicly available at          pulses, vegetables and fruits, spices, oil and ghee, as
two basic subgroup levels:                                   well as sugar and sugar related products remained
(i) Food and Beverages group                                 highly volatile during the review period owing mainly
(ii) Non-food and Services group.                            to the supply side fluctuation. Moreover, fuel, light
                                                                                                   INFLATION     335

and water witnessed a high volatility within the non-      to change - thus affecting growth - and will also
food and services group with a standard deviation          change the price level - thus affecting inflation.
of 7.4 percent due to mainly to the unplanned and
abrupt upward revision of the prices of government              P
controlled goods.                                                                                    Aggregate
                                                                                                     Supply
    In this way, during the period 1973 to 2004,
inflation in Nepal averaged at 9.0 percent, with a
standard deviation of 5.0 percent. Out of the 33                               AD
years under study, 12 years witnessed double digits
inflation. Only in one year the growth in the rate of
inflation was negative. Cumulative inflation has been                  AS
                                                                                                     Aggregate
more than 288 percent between 1973 and 2004.                                                         Demand
Historical inflationary experience in Nepal has                                                                  Y
reflected that factors like money supply, government                                  Y0     Y*
expenditure, real GDP, Wholesale Price of India                                     Output
(WPI), exchange rate can mainly be attributed to the
growth in the inflationary pressure felt by the Nepalese       However, it is to be noted that one of the crucial
economy.                                                   points about macroeconomics adjustment is that the
                                                           aggregate supply curve is not a straight line. The above
Review of Theories of Inflation
                                                           figure shows that at low levels of output, below
   The key concept in analysing output, inflation,
                                                           potential output Y*, the aggregate supply curve is quite
growth, and the role of policy are aggregate demand
                                                           flat. When output is below potential, there is very little
and supply. The level of output and the price level
                                                           tendency for prices of goods and factors (wages) to
are determined by the interaction of aggregate
                                                           fall. Conversely, for output above potential, the
demand and aggregate supply.
                                                           aggregate supply curve is steep and prices tend to rise
   Aggregate demand is the relationship between
                                                           when demand increases. The aggregate demand curve
spending on goods and services and the level of
                                                           can be shifted by monetary and fiscal policy measures..
price whereas the aggregate supply curve specifies
                                                               Literature in economics however indulges in the
the relationship between the amount of output firms
                                                           following four basic theories in explaining the
produce and the price level. Supply shocks can reduce
                                                           inflationary process. They are: excess demand theory,
output and raise prices.
                                                           cost-push theory, Phillips curve theory and the
                                                           structural theory (Khatiwada, 1994).

              Aggregate         Aggregate                  Excess Demand Theory
              Demand            Supply                        Excess demand theory argues that prices rise
                                                           because aggregate demand generated by money
                                                           supply (monetarist perspectives) or government
       P0                                                  expenditure (Keynesian perspective) exceeds the level
                                                           of output in the economy. The upward movement
                                                           of the aggregate demand curve, given the aggregate
                                 AD                        supply cur ve, raises the price in the economy.
                                                           Obviously, money supply higher than the desired level
                                                   Y       creates the situation of “too much money chasing
                          Y0
                                                           too few goods”, and this generates an inflationary
                               Output
                                                           pressure in the economy. Without the support of
                                                           money supply, inflation cannot last for a long period.
   The basic tools for analysing output, the price         Moreover, the government expenditure, particularly
level, inflation and growth are the aggregate supply       deficit financing by overdrawing from the central
and demand curves. Shifts in either aggregate supply       bank also creates the same effect as in the case of
or aggregate demand will cause the level of output         increase in the money supply.
336    NEPAL RASTRA BANK IN FIFTY YEARS

    The monetarist version of excess demand theory          interest rates, and cost of raw materials can increase
of inflation states that if the country has no excess       the cost of production generating price rise in the
productive capacity, excess supply of money over            economy. Structural rigidities in the developing
demand is reflected by the rising prices. Given that        countries also raises the cost of production or creates
there is full employment or productive capacity has         a situation of supply irresponsive to market demand,
been exhausted, increase in money supply exerts a           pushing the price level up.
proportional increase in prices. Although Nepalese              From the external front, depreciation or
economy is well below the full employment level,            devaluation of the domestic currency has the similar
there is inelastic supply of production due to structural   effect as increase in cost. The change in the exchange
rigidities. As such, money supply can affect prices in      rate not only affects prices of imported goods but
Nepal substantially. Between 1959/60 to 2003/04,            also affects prices of domestic goods produced
narrow money increased by 15.6 percent on an                using imported raw materials and capital goods.
average and considering the real GDP growth rate
                                                            Phillips Curve Theory
of about 4.0 percent during 1972/73 to 2003/04,
                                                                The Phillips curve model shows trade-off
on an average, the growth of money seems to be in
                                                            between unemployment and money wages (prices):
excess of the demand for it.
                                                            the lower the unemployment, the higher will be the
    If the supply side of the economy is responsive,
                                                            wage. Since labour cost plays a significant role in cost
excess demand generated by the monetary sector may
                                                            of production, wage rise reflects a higher level of
not be reflected on prices, it may then be reflected
                                                            price. According to this theory, inflation is due to the
on the level of output. Because of subsistence level
                                                            declining level of unemployment.
of farming, structural bottleneck and easy access to
                                                                The following figure presents a typical down ward
Indian market for the smooth supply of goods and
                                                            sloping Phillips Curve showing that high rates of
services, the above case does not prevail in the
                                                            unemployment are accompanied by low rates of
Nepalese pretext. The growth in real GDP of 4.0
                                                            inflation and vice versa. The curve suggests that less
percent on an average directs towards the
                                                            unemployment can always be attained by incurring
insufficiency of domestic supply situation to meet
                                                            more inflation and that the inflation rate can always
the demand generated by the rapidly growing
                                                            be reduced by incurring the costs of more
population accentuated by expansive monetary and
                                                            unemployment. Hence there seems to be a trade off
fiscal policies.
                                                            between inflation and unemployment.
    Increase in government expenditure can also exert
                                                                However, the modern view suggests that in the
inflationary pressure over the economy, particularly
                                                            long run the Phillips curve is almost vertical having
through deficit financing. However, as the impact
                                                            no trade-off between unemployment and inflation,
of budget deficit on prices can be captured by the
                                                            as such unemployment ultimately runs down to the
money supply variable, it is imperative to include
                                                            national rate.
aggregate expenditure as a factor for inflation.
                                                                However this is hardly the situation in developing
Government expenditure has a monetary implication
                                                            countries like Nepal where unemployment and
through foreign aid or deficit financing or through
                                                            underemployment are an ever lasting problem. Due
crowding out effect on economic resources.
                                                            to downward wage rigidity, the developing countries
However, expansionary aggregate demand policies
tend to produce inflation unless they occur when the
economy is at high levels of unemployment. In case
                                                                Inflation
of depression, expansionary policies may not
produce inflation.
Cost-Push Theory                                                    O                                   Unemployment
   However, the cost-push theory emphasizes on
the supply side and asserts that prices rise because of
increased cost of production. The left upward                                          Phillips Curve
movement of aggregate supply curve also pushes
the price level up in the economy. Rise in wages,
                                                                                                INFLATION    337

like Nepal can have higher unemployment and higher                V= Income velocity
inflation simultaneously. In other words, the                     Y= Volume of real income
developing countries generally face situation of              This theory asserts that the changes in money stock
stagflation.                                              will cause changes in prices under the assumption
                                                          that the volume of real income is determined
Structural Theory
                                                          independent of money stock. The income velocity
    The structural theory of inflation suggests that
                                                          and the volume of real income are assumed as
structural bottlenecks or such characteristics existing
                                                          constant in the short run. In other words V is stable,
in the economy are mainly responsible for inflation.
                                                          Y is at full employment level, hence P is directly
This approach to the inflation argues that the nature
                                                          proportional to quantity of money supply.
of the inflation in the developing countries cannot
                                                              Based on this theory, a bivariate regression between
adequately be determined with reference to the level
                                                          price and money gives the following results.
of aggregate demand only.
                                                              dln(cpi) = 0.003 + 0.55 dln (AM1) ... (1)
    This theory is especially relevant in the case of
                                                                             (0.11) (2.59)*
developing country like ours because there are many
                                                              Adj R2 = 0.16, DW = 1.56, F =6.7,
structural issues or rigidities in the economy such as
                                                                    AIC =-3.40, SC =-3.31
lack of transportation, black marketing, artificial
                                                              dln(cpi) = 0.007+ 0.46 dln(AM2)            ... (2)
shortages of consumer items, subsistence level of
                                                                             (0.17) (2.06)**
production, existence of saving-investment gap and
                                                              Adj R2 = 0.098, DW = 1.60, F =4.3,
government regulation of prices. As a result, the
                                                                    AIC =-3.33, SC =-3.24
economy continuously faces price rises due to the
                                                          t-statistics in parenthesis
scarcity in supply.
                                                          * significant at 1 percent significant level
Determinants of Inflation in Nepal                        ** significant at 5 percent significant level
    Economists in explaining the causes of inflation      where,
have come up with various theories and of them the            CPI = Consumer Price Index
demand side source of inflation has generated the             AM1 = Average Narrow Money Supply
theory of excess demand, (persistent excess in                AM2 = Average Broad Money Supply
demand over supply) while the supply side source              d       = difference
of inflation has given birth to the cost-push theory          ln      = natural log
and the Phillips curve.                                       Equation (1) reveals that the coefficient of money
    The excess demand theory as discussed above           supply is significant. The regression results indicate
postulates that prices are prone to escalate when there   that among the two monetary aggregates, narrow
is monetary expansion in excess of growth in real         money affects the inflation level more than broad
output. Based on the excess demand theory, inflation      money. One percent increase in narrow money may
is viewed as the result of increase in aggregate          result in 0 .55 percent increase in the inflation level
demand either by monetary expansion or increase in        whereas one percent increase in broad money
government spending through deficit financing.            increases the level of inflation by 0.46 percent only.
Classical economists always argued that inflation is a    However, the explanatory of power of above
monetary phenomenon, on the assumption of small           equations is very low. The first equation explains only
government and full-employment level of output in         16 percent variation in inflation while the second
the economy.                                              equation explains only 0.09 percent. Although this
    This argument is represented by the famous            results may not be generalised, it at least indicates
Quantity Theory of Money, according to which the          that in Nepal narrow money influences the level of
relationship between money supply and prices can          inflation more than the broad money. The above
be established as:                                        specification of the price equation is in closed
       MV = PY                                            monetarist framework.
    Where ,                                                   Aggregate demand may also be influenced by
       M = Quantity of money supply                       the increase in government expenditure too. As such,
       P = Level of price                                 inclusion of total government expenditure as an
338    NEPAL RASTRA BANK IN FIFTY YEARS

explanatory variable in the above model gives the                to India and any shortage of supply is fulfilled by
following results.                                               importing from India.
   dln(cpi) = -0.008 + 0.51 dln (AM1) + 0.12 dln (GEXP)... (3)       Inflation in Nepal can be looked upon from both
                 (-0.23) (2.35)**         (0.98)                 the demand and supply side simultaneously as inflation
   Adj R 2 = 0.16, DW = 1.72, F =3.8, AIC =-3.37, SC =-3.23      here is generally observed as the outcome of the
t-statistics in parenthesis                                      interaction of several factors. Hence putting together
* significant at 1 percent significant level                     all of the above mentioned explanatory variables in
** significant at 5 percent significant level                    a single model and running a regression, we get the
where,                                                           following results.
    CPI = Consumer Price Index                                       dln(cpi) = -0.007 + 0.51 dln (AM1)
    AM1 = Average Narrow Money Supply                                               (-0.19) (2.30)**
    GEXP = Total Government expenditure                                     +0.12 dln (GEXP)-0.02 dln (RGDP)... (5)
    d          = Difference                                                   (0.95)              (-0.068)
    ln         = Natural log                                         Adj R = 0.13, DW = 1.72, F =2.48,
                                                                            2

    Inclusion of government expenditure in the                             AIC =-3.30, SC =-3.12
model has not changed the explanatory power of                   t-statistics in parenthesis
the model. Further, the coefficient of government                * significant at 1 percent significant level
expenditure is statistically insignificant.                      ** significant at 5 percent significant level
    Moreover, if the supply side of the economy is               where,
responsive to the aggregate demand, then the chance                  CPI       = Consumer Price Index
of price rise will be meagre. This however implies                   AM1 = Average Narrow Money Supply
that excess demand generated by the monetary sector                  GEXP = Total Government expenditure
will not be reflected on the prices but it may be                    RGDP = Real GDP
reflected on the level of output. In order to capture                d          = Difference
the supply side situation, change in price has been                  ln         = Natural log
regressed with the growth of real GDP. The empirical                 The explanatory power of the model has not
result is shown as:                                              changed significantly even after combining the
    dln(cpi) = 0.084 + 0.01 dln(RGDP) ... (4)                    variables together. Except, for money supply,
                 (5.43) (0.033)                                  coefficients of all the other variables have been found
     Adj R = 0.03 DW = 1.41, F = 0.00
             2
                                                                 statistically insignificant though they have the
t-statistics in parenthesis                                      theoretically expected sign.
* significant at 1 percent significant level                         The above models are however a ‘closed economy
** significant at 5 percent significant level                    monetarist’ type od model in which only indigenous
where,                                                           variables are responsible for inflation.
    CPI        = Consumer Price Index                                The foregoing analysis has indicated that
    RGDP = Real GDP growth                                       indigenous factors of inflation have not been able to
    d          = Difference                                      fully explain the behaviour of prices in Nepal. Given
    ln         = Natural log                                     the pegged nature of the exchange rate with Indian
    The above model shows a very poor fit                        currency since 1960, external prices and the exchange
    The very insignificant coefficient on real income            rate together can generate both the demand-pull and
shows that the domestic output has not been able to              cost-push types of inflation. Since Nepal has to
exert any pressure on prices. This reflects that in Nepal        import industrial raw materials and capital goods,
because of several factors such as subsistence level             inflation in Nepal can highly be influenced by the
of farming with no price responsiveness, structural              external shocks, particularly by the Indian prices.
bottlenecks on the expansion of production in the                Although the initial effect of external prices falls on
short run and easy access to Indian market for the               the traded goods, it may also be transmitted to the
supply of goods and services, the real GDP has not               non-traded goods later on.
been successful in meeting the demand generated in                   As such, inclusion of Indian prices may be more
the economy. Any over production can be exported                 relevant in analyzing the behaviour of prices in Nepal.
                                                                                                     INFLATION     339

Indian prices exert an impact on the Nepalese prices             Adj. R2 = 0.47, DW = 1.64, F =9.41*,
in two ways. First, change in prices in India leads to a                AIC = -3.88, SC =-3.70
change in the import prices of both consumer goods           t-statistics in parenthesis
and capital goods as well as industrial raw materials.       * significant 1 percent significant level
Second, when prices in India are high, Nepalese              ** significant 5 percent significant level
goods get their ways to India creating supply shortages          dln(cpi)) = -0.014 + 0.44dln(am1)
and eventually raising the prices in Nepal (IDS, 1994).                        (-0.49) (2.36)**
Actually, “law of one price” tends to exist between                         + 0.46dln(WPI) - 0.01dln(XUS $) ... (8)
Nepal and India because of open border and close                              (3.68)*           (-0.20)
as well as big trading partner.                                  Adj. R2 = 0.36, DW = 1.75, F =6.66*,
    The following equation regressed with only                          AIC = -3.72, SC =-3.54
money supply and Indian wholesale price as the               t-statistics in parenthesis
explanatory variable, gives the estimation as:               * significant 1 percent significant level
   dln(cpi)) = -0.015 + 0.43dln(am1) + 0.45dln(WPI)... (6)   ** significant 5 percent significant level
                (-0.52) (2.39)**      (3.76)*                    The coefficient of exchange rate with the Indian
   Adj. R2 = 0.39, DW = 1.80, F =10.35*,                     currency (equation 7) possess the expected sign and
        AIC = -3.79, SC =-3.65                               is statistically significant whereas that with the US
t-statistics in parenthesis                                  dollar (equation 8) is statistically not significant and is
* significant 1 percent significant level                    with theoretically wrong sign thereby reflecting the
** significant 5 percent significant level                   importance of the Nepalese exchange rate with
     Inclusion of Indian wholesale price as an               Indian currency. Thus, this supports the argument
explanatory variable has improved the explanatory            for the pegged exchange rate with the Indian currency.
power of the model from 16 percent to 39 percent.            Any change in NC-IC exchange rate among others,
AIC and SC, with the lowest value so far seems also          affects the price in Nepal significantly.
to have favoured this model.                                     Further to the above analysis, a general model of
     Another external factor that may have an impact         the following type including wholesale price Index
on the domestic prices is changes in the exchange            of India and exchange rate with the Indian rupees as
rate of the domestic currency vis- a- vis the currencies     the explanatory variable has been estimated
of the trading partners. In fact depreciation of the             dln(cpi) = a0+a1dln (am1)+a2dln(GEXP)
domestic currency exerts a similar shock on the                         +a3 dln(RGDP)+a4dln(WPI)+a5dln(XIC)
                                                                 Here: a1>0, a2>0, a3<0, a4>0, a5>0
domestic price as the increase in the foreign price in
                                                             where,
foreign country
                                                                  CPI = Consumer Price Index
     Nepal has devalued the Nepalese rupees time and
                                                                  AM1 = Average Narrow money supply
again. Since Nepal’s manufacturing goods are based
                                                                  GEXP = Government expenditure
on imported raw materials and capital goods, the
                                                                  RGDP = Real Gross Domestic Product
depreciation or devaluation of the Nepalese rupees
                                                                  WPI = Wholesale Price Index lagged of six
is likely to affect prices through cost-push factor. As
                                                                               month
such it becomes imperative that exchange rate be
                                                                  XIC = Exchange rate NRs/IC
also included as one of the explanatory variable in
                                                                  ln        = natural log
the estimating equation.                                          d         = difference
     The following equations (7) and (8) have been               The estimating equation gives the following results
estimated including exchange rate of Nepalese rupee             dln(cpi)) = -0.003 +0.37dln(am1) -0.003dln(GEXP)
with Indian currency and that with the US dollar                            (-0.085) (2.09)**     (-0.027)
respectively as explanatory variable. The results are              -0.21dln(RGDP) +0.50dln(WPI) +0.47dln(XIC) ..(9)
as follows:                                                         (-0.91)           (4.12)*        (2.16)**
                                                                Adj. R2 = 0.44, DW = 1.55, F = 5.56*,
     dln(cpi)) = -0.009 + 0.37dln (am1)
                                                                     AIC = -3.79, SC =-3.51
                   (-0.36) (2.13)**                          t-statistics in parenthesis
               + 0.49dln (WPI) + 0.47dln (XIC) ... (7)       * significant 1 percent significant level
                  (4.25)*           (2.17)**                 ** significant 5 percent significant level
340    NEPAL RASTRA BANK IN FIFTY YEARS

    The explanatory power of the above equation is                 In this equation also, the coefficient on money
44 percent.                                                    supply and Indian WPI are found to be significant,
    Except for the coefficient of government                   but the coefficient on inflationary expectation is not
expenditure, all the other coefficients have the               statistically significant. Hence, expectation of price
expected signs. The coefficients of average money              rise does not bear any statistical significance on the
supply, wholesale price of India and exchange rate             current level of price. It also reflects lack of
with Indian currency have been found to be                     dynamism in the economy (equation 11)
statistically significant indicating that these are the most       Finally, dropping the insignificant variables like
important determinants of inflation in Nepal.                  government expenditure, real GDP, inflationary
Although government expenditure does not seem                  expectation, and lag value of money supply from
to be influencing the price level directly, its indirect       the above model and estimating the equation we get
effects through the monetary expansion cannot be               the following results.
ruled out.                                                         dln(cpi)) = -0.009 + 0.37dln(am1) + 0.50dln(WPI)
    The insignificant coefficient on real income on                              (-0.362) (2.13)**       (4.25)*
the other hand shows that the domestic output has                                               + 0.46dln(XIC) ... (12)
not been successful in exerting significant effect on                                             (2.16)**
prices. The coefficient on money supply indicates that             Adj. R = 0.47, DW = 1.64, F = 9.41*,
                                                                            2

each ten percent change in money supply causes 3.7                      AIC = -3.89, SC =-3.70
percent change in the rate of inflation in Nepal.              t-statistics in parenthesis
 The above equation is estimated also including one            * significant 1 percent significant level
year lag value of narrow money and we get the                  ** significant 5 percent significant level
following results                                                  The explanatory power of the model has increased
   dln(CPI)= 0.07 + 0.44dln(am1)– 0.16dln(am1(-1))             to 47 percent. All coefficients are significant and have
               (0.22) (2.13)**       (-0.66)                   the expected sign (equation 12). The model however
      –0.01dln(GEXP)–0.19dln(RGDP)+0.55dln(WPI)                suggests that 53 percent of the change in inflation
       (-0.10)           (-0.80)          (3.82)*              level still remains to be explained.
                                 +0.44 dln (XIC) ... (10)          This suggests that besides the quantitative factors,
                                 (1.90)**                      there are several qualitative factors that affect the
   Adj. R2 = 0.43, DW = 1.63, F = 5.56*,
                                                               prices in Nepal. The effects of administered prices,
        AIC = -3.74, SC =-3.41
                                                               supply bottleneck due to market imperfection,
* Significant at 1 percent level
                                                               underdeveloped transportation and communication
** Significant at 5 percent level
                                                               network as well as artificial shortage are some of
***Significant at 10 percent level
                                                               them. Moreover, the country has fragmented markets
    Including the lag of narrow money has not                  and pocket economics, because of which the surplus
improved the explanatory power of the model at                 supply pocket may be exporting essential supplies to
all and the coefficient of lag value of average money          India and the deficit pockets may be importing the
supply is also obser ved to be insignificant.                  same from India at higher prices, thereby inviting
Furthermore, including the inflationary expectation            inflation into the economy.
in the model and excluding the insignificant variables             In addition, excessive government intervention
from the above model, we get the following results.            in economic activities, now and then, and regulation
   dln(CPI) = -0.014+ 0.35dlag(am1)+0.46 dlag(WPI)             of the economy in the past have also contributed to
               (-0.50) (2.00)***    (3.60)*                    the distortion of price in the market. Controlled trade
                +0.51 lag(XIC)+0.098 lag (CPI(-1)) ... (11)    and dual foreign exchange rate regime in the past
                  (2.23)**       (0.64)                        had often created monopoly in the imports of goods
   Adj. R = 0.43, DW = 1.63, F = 5.56*,
          2                                                    and services. As a result, the determination of market
        AIC = -3.74, SC =-3.41                                 prices relied on the discretion of the monopolists.
* Significant at 1 percent level                               The inefficiency of a large number of public
** Significant at 5 percent level                              enterprises, involved in acquiring and distributing
***Significant at 10 percent level                             essential commodities in the country, is also highly
                                                                                                         INFLATION      341

responsible for aggravating the inflationary pressure              In other terms, time series data need to be tested
in Nepal. In addition, frequent upward revision of             for stationary, because if the estimating equation is
administered prices has also been equally contributing         having non- stationary variables then it may give rise
to the price rise in Nepal.                                    to spurious relationship and lead to incorrect statistical
                                                               inferences.
Stationarity, Co-integration Test, and Error
                                                                   The graph of the variables (level) in the model
Correction Model                                               reflect non-stationarity situation (graph.1.) indicating
Stationarity Test ( Unit Root Test)                            that the variables must have a unit root. Therefore,
     The practice of exploiting information contained          unit root test with a view to identifying the order of
in the current deviation from an equilibrium                   integration of the selected time series is performed.
relationship, in explaining the path of a variable, has        The selected method for the unit root test is the
benefited from the concept of co-integration                   Augmented Dickey Fuller (ADF) test.
propounded by Granger,1986 and Engle and                           The results of the ADF is presented in Table 2.
Granger,1987.
     A series that is tending to grow over time cannot be       Table 2
stationary (although it may possibly be stationary around       Unit Root Test
some deterministic trend), but the changes in that series                                         Mackinnon Critical Value
might be stationary. In the long run, two or more series        Variables    ADF Text            1%        5%         10%
can move closely together and the difference between
                                                                Log(CPI)           -0.92        -3.67     -2.96       -2.62
them can be constant even when the series themselves            dlog(CPI)        -4.24*         -3.68     -2.97       -2.62
are trended. A series is said to be integrated of order         log(AM1)           -0.58        -3.67     -2.96       -2.62
                                                                dlog(AM1)        -3.57*         -3.68     -2.97       -2.62
d, denoted as I (d), if it has to be differenced d times        log(RGDP)           0.44        -3.67     -2.96       -2.62
before it becomes stationary (Engle and Granger, 1987).         dlog(RGDP)         -5.31        -3.68     -2.97       -2.62
A stationary time series has a time independent mean            log(GEXP)      -2.89***         -3.67     -2.96       -2.62
                                                                dlog(GEXP)      -3.01**         -3.68     -2.97       -2.62
i.e. a constant mean and is homoscedastic. It is observed       log(WPI)           -0.27        -3.68     -2.97       -2.62
that most economic variables are non-stationary and             dlog(WPI)        -4.37*         -3.69     -2.97       -2.62
they follow a random walk (Granger, 1986). A non-               log(XIC)           -1.66        -3.67     -2.97       -2.66
                                                                dlog(XIC)        -3.68*         -3.68     -2.97       -2.62
stationary series within the framework of ordinary least
                                                                *   = significance at 1 percent level
square (OLS) estimation violates its basic assumption           ** = significance at 5 percent level
and as such one cannot get the best unbiased linear             *** = significance at 10 percent level
estimates (BLUE). According to Phillips (1986), the
asymptotic theory within a non-stationary process is               The results of ADF test show that time series
completely different from that with a stationary process.      data (level) are not stationary but the first difference
However, even if there exists a spurious correlation           of the series are however found to be stationary. As
between non-stationary variables, the basic statistical test   such, the above OLS estimates have been done in
may still be significant, though it still violates the BLUE    first difference of the time series. The ADF test also
property (Grange and Newbold, 1974). There are no              reveals that the time series data are integrated of order
limiting distribution for t-ratios for regressions between     I(1), as such, hence, we can move towards
I (1) variables, R2 has a non-degenerate limiting              performing the co-integration test. Although the data
distribution and the Durbin Watson statistic tends to          in level are non-stationary, they can have co-
converge towards zero. To establish the existence or           integrating relation.
non-existence of a long run equilibrium relationship
                                                               Co-integration Test
between two economic time series x and y, we must
                                                                  Cointegration test shows the long run relationship
first test whether ‘x’ and ‘y’ variables are integrated to
                                                               between the variables under consideration. Two time
the same order. Stationarity test of these variables reveals
                                                               series are said to be co-integrated of order d,b
the order of integration following the Augmented
                                                               denoted I(d b) if they both are integrated of order
Dickey Fuller test (Dickey & Fuller, 1981). If both
                                                               d but there exists some linear combination of them
variables are I(1), then the test for co-integration can be
                                                               that is integrated of order b<d (Engle and Granger,
performed by using residuals of OLS estimates
                                                               1987).
(Graph 1).
342    NEPAL RASTRA BANK IN FIFTY YEARS

Graph 1
Data in Level

        5.5                                                     12

        5.0                                                     11

        4.5
                                                                10
        4.0
                                                                 9
        3.5
                                                                 8
        3.0

        2.5                                                      7

        2.0                                                      6
              75     80     85       90      95   00                 75    80     85        90      95   00

                                  LOG(CPI)                                              LOG(AM1)



        5.0                                                   12.8

                                                              12.6
        4.5
                                                              12.4

        4.0                                                   12.2

                                                              12.0
        3.5                                                   11.8

                                                              11.6
        3.0
                                                              11.4

        2.5                                                   11.2
              75     80     85       90      95   00                 75    80     85        90      95   00

                                 LOG(WPI)                                               LOG(RGDP)



        12                                                    0.55

        11
                                                              0.50

        10
                                                              0.45
          9
                                                              0.40
          8

                                                              0.35
          7

          6                                                   0.30
              75     80     85       90      95   00                 75    80     85        90      95   00

                                 LOG(GEXP)                                               LOG(XIC)


 Source: Based on data in Appendix 2.

   As seen in table 2, the variables under                   Empirical results of equation (10) is as follows.
consideration are stationary only in the first difference.      ln(CPI) = -4.5 + 0.1 ln(am1)-0.02 ln(GEXP)
As such, we can perform the co-integration test
among these variables (level). If the variables are co-                  (-1.57) (1.25)      (-0.22)
integrated, the residual of the following model                  +0.34 ln(RGDP)+0.64 ln(WPI)+0.63 ln(XIC) ... (14)
should be stationary.                                             (1.14)       (3.67)        (2.63)
   ln(cpi)) = a0 + a1ln(am1)+a2ln(GEXP)                      Adj R2 = -0.99 dw = 0.87
 +a3 ln(RGDP) +a4ln(WPI) +a5ln(XIC)+ e …(13)
                                                                                                       INFLATION     343

Graph 2                                                         but avoid the problem of losing long run information
Movement of Residuals                                           on data. ECM reveals both short-term relationship
                                                                and the adjustment toward the long run equilibrium.
  0.08                                                          Hence, the ECM model is formulated as follows.
  0.06                                                              Dln(CPI) = bo+bifDln(X)+b3et-1+dt … (15)
  0.04                                                          where X is a set of explanatory variables
  0.02
                                                                    More specifically, the following ECM model is
                                                                estimated.
  0.00
                                                                   Dln(CPI) =bo+b1Dln(am1)+b2Dln(GEXP)+b3Dln(RGDP)
  -0.02
                                                                              +b4Dln(WPI)+b5Dln(XIC)+b6et-1+dt… (15a)
  -0.04                                                             Empirical results of above ECM model is shown
  -0.06                                                         in equation (16)
  -0.08                                                            Dln(CPI) = 0.02 + 0.43Dln(am1)-0.03Dln(GEXP)
          75    80      85      90       95     00                             (-0.70) (2.64)*        (-0.37)
                         LOG(CPI) Residuals                                            -0.005+Dln(RGDP)+0.59Dln(WPI)
                                                                                       (-0.02)                 (5.07)*
                                                                                             +0.71Dln(XIC)-0.45et-1 … (16)
    The graph 2 of residual and the following ADF                                            (-2.47)*         (1.58)
test of residual confirm that residual of the model                AdjR2 = 54, DW = 1.45, F = 6.63*
shown in equation (10) is stationary at 5 percent level             The coefficient of error term is found to be
of significance. Hence, It can now be inferred that             statistically significant and the value of coefficient
variables under consideration are co-integrated to              implies that 0.45 percent of disequilibrium in CPI in
each other. As such, inflation in Nepal is seen to have         any one year is made up within the next year.
a long run relationship with money, Indian price,               Inflation Controlling Measures
government expenditure, domestic production and                     Inflation, like unemployment, is a major
change in the exchange rate with Indian currency.               macroeconomic concern. However, the costs of
 Table 3                                                        inflation are much less obvious than those of
 ADF Test on Residuals                                          unemployment. But consumers dislike inflation
                                                                because it is often associated with disturbances, such
 ADF Test Statistic -3.550009 1% Critical Value*      -3.6752
                              5% Critical Value       -2.9665   as the oil price shock that reduce their real income. It
                              10% Critical Value      -2.6220   is also argued that inflation upsets familiar price
 * MacKinnon critical values for rejection of hypothesis of a   relationships and reduces the efficiency of the price
   unit root.                                                   system.
                                                                    Although some economists argue that a mild
Error Correction Model (ECM)                                    inflation is desirable for economic growth,
    In economics controlled experiments are not                 inflationary situation is not preferred in general. It
possible. Variables are stochastic and much of the              actually creates macroeconomic instability and distorts
data consists of non-stationary time series as found            resources allocation in the economy. More
above, as such we can’t rely on the standard regression         importantly, inflation aggravates the poverty by
procedure (OLS). As the variables are non-stationary,           increasing inequality and lowering the purchasing
the OLS estimators have sampling distribution with              power of money. It also brings uncertainty in the
properties very different from what we know so                  economy distorting both savings and investment
far. OLS estimation in non-stationary variables                 decisions. Hence, price stability has been the major
produces spurious result while estimation in first              concern of monetary policy in Nepal. Price stability
difference looses the long run relationship among               implies the low and stable level of inflation in the
the variables. Hence, ECM is a modelling technique              economy.
that captures both long run relationship and short                  The determinants of inflation identified above
run dynamics. A major advantage of error-correction             set the direction in finding the measures to contain
model is that they result in equation with first                inflation in the economy. It has been found that
differenced and hence stationary dependent variable             inflation in Nepal is influenced by both the demand
344    NEPAL RASTRA BANK IN FIFTY YEARS

and supply side factors. Hence, there should be a            Concluding Remark
policy mix to combat inflationary situation in Nepal.            A review of price movement during the period
    The econometric study revealed that money                1973 to 2004 revealed that inflation in Nepal stood
supply is a significant factor in determining the            at an average of 9.0 percent with a standard deviation
inflation in the Nepalese economy. As such, to avoid         of 5.0 percent. Out of a period of 33 years under
an inflationary situation in the economy, money              review, 12 years witnessed the double digits inflation.
supply should be regulated according to its demand.          Only in one-year (1995/76), inflation was found to
However, without the support of the monetary                 be negative. Cumulative inflation has been more than
policy, inflation cannot last long; hence, monetary          288 percent between 1973 and 2004.
policy should be geared toward achieving price                   An econometric analysis in identifying the causes
stability in the economy.                                    of inflation in Nepal revealed that domestic prices
    Another measure could be the fiscal consolidation        are influenced by both the monetary and structural
for containing inflation. The government should              factors. Empirical results confirm that Indian prices,
control the monetization of budget deficit. It has           money supply and exchange rate changes are the most
been a well-established fact that increasing the             significant determinants of inflation in Nepal.
government expenditure could crowd out the private           Moreover, inflation in Nepal has long run relationship
sector investment thereby increasing the inflationary        with money supply, Indian WPI, government
pressure in the economy. Moreover, deficit financing         expenditure, real GDP, and exchange rate. Further,
through overdraft from the central bank is highly            the significant coefficient of error correction term
inflationary. In Nepal, however, Nepal Rastra Bank           establishes the fact that the long run effects are being
Act 2058 has imposed a limit on the overdraft                felt after the period of one year and about 45 percent
amount that the government can utilise at a time.            of any disequilibrium in CPI in any one year is being
    Given the pegged nature of exchange rate system          made up within the next year.
with the Indian currency, inflation in Nepal is directly         It has been noted that the conventional measures
influenced by the Indian prices. In the recent years,        of price by consumer price index (CPI) cannot
the Indian economy, while growing at a higher rate,          however, isolate the supply shock effect on the price
is also maintaining price stability. As such, inflation in   movement with which monetary policy has negligible
Nepal has been comfortable benefiting from such a            relationship. For the accountability and credibility of
situation in India. In fact, the pegged exchange rate        the monetary policy with regard to price stability
system with the Indian currency has been contributing        objective, there should be a measurement of core
in maintaining price stability in Nepal so far.              inflation, eliminating distortionary effects of supply
However, with more financial sector liberalisation in        shocks (Shrestha, 2002). With the further liberalization
days to come, especially after capital account is made       of the economy and the adoption of capital account
fully convertible, the Nepalese exchange rate system         convertibility, Nepal needs to adopt a flexible
with Indian currency needs to be more flexible. This         exchange rate regime. Hence, monetary policy needs
calls for a proactive monetary policy in Nepal.              to set a single goal of price stability, adopting inflation
    Besides the main determinants, inflation in Nepal        targeting regime.
has also been found to be affected by qualitative                So long as the controlling the inflation is
factors like the effects of administered prices, supply      concerned, it becomes imperative to devise both
bottleneck due to market imperfection,                       demand and supply management policies in Nepal.
underdeveloped transportation and communication              The growth of money supply should be managed
network as well as artificial shortages. Going through       properly. Since money supply in Nepal is highly
the history of inflationary situation in the country, as     influenced by the net foreign assets (NFA), sterilization
it has been observed, increment of the domestic              through effective open market operation is very vital
prices has, in one way or the other, been associated         in managing money supply in Nepal. To further
with structural bottlenecks (Mathema, 1994). As such,        mitigate the possible spill over impacts from the
concrete policy must be pursued to ensure an effective       change in Indian price, it would be a wise idea to
management of the supply of essential goods in the           have an effective supply management system such as
economy.                                                     maintaining buffer stocks and monitoring the price
                                                             of non-tradable goods.
                                                                                                      INFLATION    345

Endnotes                                                           With a Unit Root”, Econometrica, vol.49, pp.1057-
   1
      The GDP deflator is the ratio of nominal GDP                 72.
in a given year to real GDP of that year. The deflator          Institute for Sustainable Development (1994),
measures the change in prices that has occurred                    “Inflation in Nepal”, Economic Review, Occasional
between the base year and the current year. Since the              Paper No.7, Nepal Rastra Bank, Kathmandu.
GDP deflator is based on a calculation involving all            Khatiwada, Y.K.(1994), Some Aspects of Monetary Policy
the goods produced in the economy, it is a widely                  in Nepal, South Asian Publishers, New Delhi.
based price index that is frequently used to measure            Mathema, S.R.(1995), Inflation in Nepal: Its Causes and
inflation.                                                         Management, unpublished report.
    The consumer price index (CPI) measures the cost            Monetary Division, NRB (2001), “Money and Price
of buying a fixed basket of goods and services                     Relationship in Nepal: A Revisit”, Economic Review,
representative of the purchases of urban consumers.                Occasional Paper, No.13, Nepal Rastra Bank,
The CPI differs from the GDP deflator in the                       Kathmandu.
following main ways:                                            NRB (1981), Nepalma Bigat Adhai Dasakko Mulya
    (i) The deflator measures the prices of a much                 Prabriti tatha Mulaya Niti: Yek bibechana, Price
          wider group of goods than the CPI does.                  Division, Kathmandu.
    (ii) The CPI measures the cost of a given basket            Shrestha, P.K.(2002), Measuring Core Inflation in
          of goods, which is the same from year to                 Nepal, Economic Journal of Development Issues, Vol.
          year. While the basket of goods included in              3, No.1, Kathmandu.
          the GDP deflator, however differs from year           Engle, R.F., and Granger, C.W.J.(1987), Cointegration
          to year, depending what is produced in the               and Error-Correction : Representation,
          economy in each year.                                    Estimation, and Testing, Econometrica, 55, pp.251-
    (iii) The CPI directly includes prices of imports,             76.
          whereas the deflator includes only prices of          Granger, C.W.J.(1986), Developments in the Study
          goods produced in the country.                           of Cointegrated Economic Variables, Oxford
    2
       Inflation data for the first two years of 1960s             Bulletin of Economics and Statistics, 48, pp.213-28.
were un-weighted price index for Kathmandu and                  Laidler, D.E.W. and Parkin, J.M.(1970), The Demand
for the remaining period, it was weighted price index              for Money in the United Kingdom 1956-1967 :
for Kathmandu complied by CBS.                                     Preliminary Estimates, Manchester School,
    3
      As said earlier, weighted national urban price index is      pp.187-208.
available since 1972/73. Obviously, it is more reliable than    Laidler, D.(1985), The Demand for Money Theories,
the previous un-weighted price index and weighted price index      Evidence and Problems, Harper and Row, 3rd ed.
for Kathmandu.                                                  Granger, C.W.J. and Newbold, P (1974), Spurious
    4
       The overall budget deficit (before grants) in-              Regression in Econometrics, Journal of Econometrics,
creased from an average of 5.9 percent of GDP                      26, pp.1045-66.
during 1976/77-1980/81 to 10.3 percent during                   Phillips, P.C.B.(1986), Understanding spurious
1981/82-1985/86.                                                   Regressions in Econometrics, Journal of
                                                                   Econometrics, 33, pp.310-40.
Reference                                                       Debelle G, Masson P, Savastano M and Sharma Sunil
Dickey, D.A. and Fuller W.A., 1981, “Distribution                  (1998), “Inflation Targeting as a Framework for
   of the Estimators for Autoregressive Time Series                Monetray Policy” IMF, USA.
346   NEPAL RASTRA BANK IN FIFTY YEARS




                               Currency Management
                                              Vishnu Nepal
                                 Director, Financial Management Department
Background                                                          Mulukikhana Adda (Government
    The beginning of the monetary system                            Treasury) started issuing Nepali currency
in Nepal may be traced to the issue of                              notes in 1945. In short, it may be said that,
the “manank” coins minted during the                                the development of metal currency in
Lichhivi period, although those coins did                           Nepal started with the growth in Nepal-
not have a definite shape, weight and size.                         Tibet trade, and that of paper currency
It was only from the reign of King                                  with the progressive expansion in Indo-
Mahendra Malla that minting of copper                               Nepal trade.
coins with definite shape, size and weight                                 Prior to the establishment of the
started. The first silver coins in Nepal,                           NRB in 1956, the task of issuing and
known as “daam”, came into circulation during the       management of the Nepalese currency was
reign of King Sadashivadeva. In the Malla period,       performed by the Sadar Mulukikhana, albeit, on a
the expansion of Nepal’s external trade with Tibet      small scale. Sadar Mulukikhana had issued a total of
promoted the circulation of the Nepalese coins both     Rs. 54.9 million from September 17, 1945 onwards
in Nepal and the Tibet. Standardization of coins        of which, notes of Rs. 39.7 million were in circulation
started from the reign of His Majesty Prithivi          as of mid- July 15, 1957. Those days, dual currency
Narayan Shah. Thereafter, the golden “asarfi” came      system existed in the country. The circulation of
into circulation during the reign of King Rana          Nepalese currency was limited to the Kathmandu
Bahadur Shah.                                           Valley and some hilly areas. Most of the government
    Paper money came into circulation in India from     transactions including revenue and expenditures were
1861 onwards. As a consequence of this and the          carried out and the bank accounts maintained in
development of railways in the Indo-Nepal border        Indian currency. Due to dominance of Indian
areas, trade with India started growing. Inability of   currency the demand for the Nepalese currency was
the Nepali metal currency to cater the growing          relatively low. The exchange rate of the Nepalese
demand for money arising from increased                 currency vis-à-vis the Indian currency was highly
commercial transactions between Nepal and India         unstable. Banking activities were also confined to a
forced public to use Indian currency as the medium      few cities. These factors placed Rastra Bank in a
of transactions in Nepal. An effort was made to         difficult position to formulate and implement
increase the supply of Nepali coins by establishing a   independent monetary policy effectively.
mint at Sundhara in 1930. But Nepal’s monetary              There was a need to promote circulation of the
system took a quantum jump only after the Sadar         Nepalese currency in place of the Indian currency in
                                                                                 CURRENCY MANAGEMENT        347

accordance with the demand of the economy on             transactions. The expansion of Rastriya Banijya Bank’s
the one hand and to monetize the non-monetized           branch network greatly helped in cultivating banking
sector on the other. It was indeed very difficult to     habit among the general public, enhancing the
establish the Nepalese currency as the national          circulation of the Nepalese currency and monetizing
currency unless the confidence of the general public     the economy. Besides, the Currency Chests were
was build up on it. The limited distribution system      established in all the districts of the Kingdom that
of the Nepalese currency and easy availability of the    helped simplifying and expediting the process of
Indian currency made the task of adequate supply         revenue collection and payment. Even to date, these
of the Nepalese currency more challenging. Against       Currency Chests have been serving as the major
this environment, the Nepal Rastra Bank was              channels for supplying the Nepalese currency.
established on April 26, 1956 as the country’s central       Over the time, management of currency notes
bank with the sole authority to make necessary           by the Rastra Bank has been more systematic and a
arrangements for managing the issue and circulation      continuous effort is being made on modernization
of the Nepalese currency.                                and mechanization of currency management. Initially,
    Nepal Rastra Bank, right from its inception,         the notes in plain paper with a watermark as the
concentrated all its efforts on establishing the         only security feature were printed in Nasik (India).
Nepalese rupee as the only legally acceptable currency   Those notes have gradually been replaced by notes
by gradually dislodging the Indian rupee all over the    printed from naturally produced cotton rag /
Kingdom. Rastra Bank took initiative to make             combers and polymer substrate (plastic) that
necessary arrangements for exchanging Nepalese and       contained the world’s ultra-modern security features.
Indian currencies, collecting governmental revenue       Similarly, the destruction and fund transfer of
in Nepalese currency and for minimizing minting of       currency notes have gone through immense
coins. With a view to support these initiatives the      modernization and the counting, sorting and
Nepalese Currency Circulation Act, 1958 and the          verification of notes have been mechanized.
Foreign Exchange Regulation Act, 1963 were                   The currency management function of the Nepal
enacted.                                                 Rastra Bank has centred on assisting the
    In order to ease the supply of the Nepalese          implementation of the monetary policy, fostering
currency and provide the exchange facility for Indian    financial deepening, monetization, and simplification
currency to the public, Rastra Bank opened exchange      of the payment system.
counters, mobile counters and depots in addition to          The currency management is not only important
branches and sub-branches. With this infrastructure      but also complex. It is not merely printing and issue
in place, the exchange rate for 100 Indian Rupees        of notes. Apart from being an extremely sensitive
was pegged for the first time at Rs. 160 with effect     issue, it has extensive perimeters. In general terms,
from April 13, 1960 for maintaining stability between    currency management implies printing, issue, supply,
the Nepalese and Indian currencies.                      and destruction of notes. However, in broad terms,
    Confidence of the Nepalese people on Nepalese        it embodies numerous tasks including: correct
currency was building up gradually and therefore,        assessment of the demand and supply situation of
the Nepalese currency was made the only legal            notes in the economy; arrangements for designing,
currency all over the Kingdom by 1967. Rastra Bank       printing, verification and reserve / security, and issue
had to make a Herculean effort for nearly one decade     and distribution of notes; operation of the Currency
of its establishment to accomplish this success.         Chest; counting and sorting of notes; fund transfer;
    In most of the remote hills and rural areas of the   exchange and reimbursement; and destruction of
kingdom, it was not possible to promote the              notes. These tasks can be grouped into three
circulation of the Nepalese currency just through a      categories: policy, technical and procedural. The policy
few branches of the Nepal Rastra Bank and Nepal          aspect encompasses tasks like assessment of demands
Bank Limited at desired level. Therefore, in 1966,       for notes of different denominations; determination
the Rastriya Banijya Bank was established as the         of the quantity of notes to be printed; increasing/
second commercial bank under state ownership with        decreasing the denominations of notes; making
major responsibility of conducting governmental          arrangements for security/reserves, whereas the
348    NEPAL RASTRA BANK IN FIFTY YEARS

technical aspect includes designing of notes; quality        and foreign bills of exchange and the remaining
of paper; security features and other specifications.        percentage shall be one or more of the coins (Mohar
The tasks that begin from issue of notes to their            Double or coins of higher denomination, the debt
destructions fall under the procedural aspect.               bond issued by His Majesty’s Government, the
                                                             promissory note or bills of exchange payable in
Legal Provisions Relating to Nepalese
                                                             Nepal within a maximum of eighteen months from
Currency Management: Nepal Rastra Bank                       the date of repayment by bank.
Act, 2002                                                            Provided that in case His Majesty’s
Section 2. Definition                                        Government so permits, at least forty percent of
    (i) “Currency note” means the bank note in               the assets to be maintained as backing for the note
circulation in the form of cash and the word also            issue may be in the form of one or more forms
includes coins.                                              among gold, silver, foreign currencies, foreign
    (k) “Nepalese currency” means the currency of            securities and foreign bills of exchange, and the
Nepalese rupee denominations .                               balance in the form of one or more from among
Section 5. Functions, Duties and Powers of                   Nepalese coins (Mohar rupee, or coins of higher
              Bank                                           denominations), Nepalese securities, promissory
    (a) To issue bank notes and coins.                       notes or bills of exchange refinanced by Nepal Rastra
Section 8. Privileges and Facilities to Bank                 Bank which are due to be redeemed inside Nepal
    (d) There would be no tax, fee, charge, duty on          within a maximum period of eighteen months.
the export and import of bank notes, coins, gold,                (3) For the purpose of sub-section (2), the
silver and the paper, metal, chemicals, and other            valuation of property shall be made as follows: -
materials to be used for printing bank notes and                 (a) The price of gold at the rate fixed by his
minting coins.                                               Majesty’s Government on the recommendation of
Section 29. Functions, Duties and Powers of                  the Board;
               Board                                             (b) The price of silver at the rate deemed
    (b) To take necessary decisions with regard to the       appropriate by the Board;
denominations of bank notes and coins, the figures,              (c) The foreign currencies at the rate fixed by the
size, metal, materials for printing notes, and other         bank;
materials; and to frame appropriate policies with                (d) The debt bond issued by His Majesty’s
regard to their issue.                                       Government, the foreign securities and bills of
Section 51. Monetary Unit                                    exchange at the rate deemed appropriate by the
    (1) The Rupee shall be the monetary unit of the          Board on the basis of market rates;
Kingdom of Nepal and such Rupee shall be divided                 (e) Coins at the rate of face value.
in one hundred Paisa.                                            (4) The Bank shall issue the bank notes of various
    (2) The Rupee referred to in sub-section (1) shall       denominations as may be necessary. While issuing bank
be a legal tender within the Kingdom of Nepal and            notes in this way, the figures appearing in the notes,
His Majesty’s Government shall provide guarantee             size and denominations shall be as approved by His
for such Rupee.                                              Majesty’s Government and the figures, internal
Section 52. Power to issue Bank Notes and                    security arrangements, invisible security features, the
               Coins                                         materials for printing bank notes and other materials
    (1) The Bank shall have monopoly over the issue          shall be as decided by the Board.
of bank notes and coins in the Kingdom of Nepal.                 (5) His Majesty’s Government may, in consultation
Such notes and coins shall be legal tenders in the           with the Board, declare that banknote of any
Kingdom of Nepal.                                            denomination shall cease to be legal tender in any
    (2) The Bank shall issue notes pursuant to sub-          place other than the prescribed place or office having
section 1(1), only against the security, and the liability   published a notification in the Nepal Gazette.
of such issued notes shall be equal to the value of              (6) The Bank shall not reissue the notes, which
property kept as security. At least fifty percent of the     are torn, defaced or excessively soiled.
property to be kept as security shall be one or more             (9) The Bank shall be responsible for payment
of gold, silver, foreign currency, foreign securities,       of the bank notes issued by the Bank and the notes
                                                                                    CURRENCY MANAGEMENT        349

issued by His Majesty’s Government prior to the            Section 59. Account of Issued Currency
establishment of the Bank.                                     The Bank shall maintain account of the entire
     (10) No liability other then the liability referred   bank notes and coins in circulation showing them
to in sub-section (9) shall be borne from the property     separately as monetary liability. Such liability shall
given as security for issuance of bank notes.              not include the bank notes and coins in stock or
Section 53. Bank-notes and Coins to be all                 not in circulation.
                Acceptable                                 Section 60. Currency Recall
     The bank notes and coins issued by the Bank having        (1) The Bank may recall the bank notes and
made them legal tender shall be all acceptable to the      coins in circulation within the Kingdom of Nepal
extent of the amount of face value for repayment           by issuing in exchange therefor other bank notes
of all types of public or private debts within the         and coins in equivalent amount. The Bank shall
Kingdom of Nepal.                                          publish and transmit public notice clearly
Section 55. Issuance of Currency and Security              specifying the period during which the bank notes
     Matters relating to printing of bank notes and        or coins must be presented for exchange and where
minting coins, providing security to the unissued          they are to be so presented.
banknotes and coins, keeping them in appropriate               (2) Notwithstanding anything contained in
manner and the matter of safe keeping or destroying        section 53, upon expiry of the time prescribed
the old banknotes or coins, plate and dies not in          pursuant to sub-section (1), bank notes and coins
circulation shall be as prescribed.                        to be exchanged shall cease to be legal tender.
     Section 56. Provisions for Exchange of Currency:          (3) The Bank may demolish, cut, break, or
     The Bank shall, without any fee or charge, change     destroy in any manner whatsoever, the banknotes
a bank note or coin with legal tender in the Kingdom       and coins withdrawn from circulation pursuant
of Nepal with the banknotes or coins of same               to sub-section (1) and the currency with defect, as
denomination or of different denominations of the          prescribed.
equal value.                                               Section 61. Reproduction and Counterfeiting
Section 57. Soiled or Counterfeit Currency                                of Currency
     (1) The Bank may withdraw, destroy or replace             (1) No person shall commit or cause to
the soiled currency with other bank note or coin.          commit any of the following acts: -
     (2) Notwithstanding anything contained in sub-            (a) To forge, counterfeit or alter bank notes
section (1), the Bank may deny to replace banknote         and coin in circulation as legal tender in the
or coin the design of which has been deleted, or           Kingdom of Nepal or any cheques or payment
torn, defaced or more then fifty percent of its portion    card or to do any other act relating to it or to
has been destroyed.                                        assist in any of such acts;
     (3) The Bank may withdraw or destroy such bank            (b) To possess, transport or issue any bank note
notes or with or without compensation to the owner         or coin or cheque or payment card with the
of the bank notes or coins referred to in sub-section      knowledge that such bank note or coin, cheque
(1).                                                       or payment card was falsely made, forged,
     (4) No owner of the lost or stolen bank notes or      counterfeited or altered or to assist in such acts in
coins shall be entitled to a reimbursement from the        any manner; or
Bank. The Bank may forfeit without any                         (c) To possess, transport any sheet of metal,
compensation, the coins or notes the outer                 stone, paper, die or any other material or substance
appearance of which is changed, or which is                with the knowledge that it was destined to be used
counterfeit coin or fake note.                             in falsely making, forging, counterfeiting or altering
Section 58. Provisions Relating to Currency                any bank note or coin, cheque or payment card
               Inventory and Issuance of Currency          or to assist in any of such acts.
     The Bank shall carry out the functions relating           (2) Any reproduction of bank notes, coins,
currency inventory and issue of currency and to            checks, securities or payment cards, denominated
regularly supply the banknotes or coins in order to        in Nepalese Rupees, and the creation of any objects
meet the demand of currency.                               that by their design imitate any such bank note,
350    NEPAL RASTRA BANK IN FIFTY YEARS

coin, check, security or payment card, shall require                Nepal Rastra Bank for the first time introduced
the prior written authorization of the Bank.                    Polymer notes of Rs. 10 denomination on September
    (3) The Bank may take appropriate action to prevent         30, 2002 during the tenure of Tilak Rawal. This was
the issue of fake note or counterfeit currency or duplicate     a shift in terms of raw materials from naturally
cheque or payment. The Bank may issue necessary order,          cultivated cotton to re-cycled polymer substrate.
directives or notices while taking such actions.                    The Old Print Notes, that is, notes printed by
                                                                Sadar Mulukikhana contained the Portrait of King
Chronology of Note Issue
                                                                Tribhuvan. Similarly, Portrait of King Mahendra was
    The Sadar Mulukikhana issued, for the first time
                                                                included in the notes printed in 1960 and that of
notes of Rs. 5, 10 and 100 denominations on
                                                                King Birendra in notes of 1974. The Portrait of
September 17, 1945. These notes had the signature
                                                                present King Gyanendra appeared in Nepalese notes
of Treasurer Janak Raj Pandey. The Re.1 denomination
                                                                for the first time in 2002.
notes were issued, for the first time, in 1952 during
                                                                    On the occasion of the Golden Jubilee
the tenure of Treasurer Narendra Raj Pandey.
                                                                Anniversary Nepal Rastra Bank has decided to print
    Nepal Rastra Bank on its own started printing and
                                                                and issue Rs. 50 denomination notes with new and
issuing notes from February 19, 1960. It was this day
                                                                attractive design.
that the Bank had issued notes of the already existing
                                                                    The issue of Nepalese currency notes in
four denominations (Re.1, Rs. 5, 10 and 100) bearing
                                                                chronological order by denomination is presented
the signature of the first Governor Himalaya Sumsher
                                                                in table 1 below.
J.B.R. Over the twelve different Governor’s tenures
notes of new denominations were issued. Currently               Special Features of Nepalese Notes
notes of eleven denominations are in circulation,                   Reflection of monarchical institution, religion,
including Re.1, Rs. 2, 5, 10, 20, 25, 50, 100, 250, 500         language, natural beauty, arts and culture of Nepal
and 1000. Notes issued after the establishment of the           and the depiction of a portrait of His Majesty with
Nepal Rastra Bank include Rs. 1000 in 1969 and Rs.              Shreepech (Crown) and watermarking of the Crown
500 in 1971 during the tenure of Yadav Prasad Pant,             are the chief features of the Nepalese currency notes.
Rs. 50 in 1977 during the tenure of Kul Shekhar                 Besides, pictures of different temples, gods and
Sharma, Rs. 2 in 1981 and Rs. 20 in 1982 during the             goddesses, the flora and fauna and the Himalayas
tenure of Kalyan Bikram Adhikary, and Rs. 250 and               are included in notes of different denominations.
                                                                From nationalism and cultural identity viewpoint
Rs. 25 in 1977 during the tenure of Satyendra Pyara
                                                                woodcrafts and stone sculptures have been used.
Shrestha. Of these, notes of Rs. 250 denomination                   The currency notes of different denominations
are commemorative notes issued on the occasion of               issued by the Nepal Rastra Bank and those currently
the accession to throne by His Majesty King Birendra.           in circulation have the following unique features:
 Table 1
 Stages of Note Issue
 Denomination           Date of Issue               Issuing Agency                  Governor
 5, 10 & 100            Sept. 17,1945               Sadar Mulukikhana               Mr. Janak Raj Pandey*
 1                      1952                        Sadar Mulukikhana               Mr. Narendra Raj Pandey*
 1, 5, 10 & 100         Feb. 19, 1960               Nepal Rastra Bank               Mr. Himalaya Samsher J.B.R
 1000                   Dec. 24, 1969               Nepal Rastra Bank               Dr. Yadav Prasad Pant
 500                    June 7, 1971                Nepal Rastra Bank               Dr. Yadav Prasad Pant
 50                     April 26, 1977              Nepal Rastra Bank               Mr. Kul Sheshar Sharma
 2                      April 26, 1981              Nepal Rastra Bank               Mr. Kalyan B. Adhikari
 20                     Nov. 8, 1982                Nepal Rastra Bank               Mr. Kalyan B. Adhikari
 250                    April 10, 1997              Nepal Rastra Bank               Mr. Satyendra Pyara Shrestha
 25                     April 11, 1997              Nepal Rastra Bank               Mr. Satyendra Pyara Shrestha
 10 (Polymer)           Sept.30, 2002               Nepal Rastra Bank               Dr. Tilak Rawal
 * Cashier (KHAJANCHI)
 Source: Nepal Rastra Bank.
                                                                                             CURRENCY MANAGEMENT           351

 Table 2
 Some Features of Nepalese Notes
 Denomi-nation Temple/ Palace                  Wildlife                 Himalayas               God /Goddess, Colour etc.

 1                 Pashupatinath               Musk- Deer
                                               (in running motion)      Dhaulagiri              –
 2                 Jay Bageswori               Leopard                  –                       Black Lentil colour
 5                 Telaju Bhabani              Yak                      –                       Kuber*
 10                Changu Narayan              Krishnasar (couple)      –                       Lord Vishnu #
 20                Krishna Mandir              Jaryo@                   –                       Almond colour
 25                Hanuman Dhoka Palace        Cow (with grey hair )    Machhapuchhre ~         –
 50                Janaki Mandir               Black- Buck              –                       –
 100               Nyatpole Dewal              Rhinoceros               Himalayan Range         Goddess Laxmi
 250               Hanuman Dhoka Palace        Cow (with grey hair )    Machhapuchhre ~         –
 500               Maitidevi                   Tiger (male )            Ganesh Himal             Goddess Saraswoti
 1000              Soyambhunath                Elephant (adult)         Gaurishankar            Goddess Dakshinkali
 @ a kind of Deer. ~ shape like tail of a Fish. * a rich person symbolizing the wealth. # mounted on the Eagle (Garuda).
 Source: Nepal Rastra Bank.

    In addition to visible features mentioned above                these security features, the Bank determines whether
Nepalese currency notes in circulation have various                a note is counterfeit or not by examining with the
technical features called technical specification. Such            available technology and equipments. The security
features by their nature are difficult for the general             arrangements in the Nepalese currency notes can be
public to understand. A few of them are listed below:              broadly divided into two categories: conventional
    Size: All notes have the same width of 70 mm.                  type and modern type.
The length, however, varies from 110 mm in Re.1                    Conventional type consists of:
notes to 172 mm in Rs.1000 denomination. Cutting                   • Paper of the note,
edge tolerance level is +/- 1.5 to 2.0 mm.                         • Admixture of colours used in the note,
    Printing Type: 1-3 Lithographic, 1-2 Letterpress,              • Size and type of note,
Single or Multi-colour Intaglio.                                   • Portrait of His Majesty with Crown,
    Paper Quality: 100 percent Cotton rag (small                   • Watermark of the Crown,
denomination) and combers (higher denomination)                    • Suki impression,
with 3 dimensional mould made watermark of His                     • Logo of the Rastra Bank,
Majesty’s Portrait and 1.2 to 4.0 mm. wide polyester               • Impression of His Majesty’s regalia,
based or de-metallised windowed security thread                    • Ordinary type security thread (except in Re. 1
reading reversed-out ‘NRB’… ‘NRB’. The polymer                         notes),
notes are made of Polymer Guardian Substrate                       • Note numbers, including prefix number,
(plastic paper).                                                   • Signature of the Governor.
    The weight of the paper is 85.0 gsm (grammes                   Modern type security features include:
per square metre ) in the case of paper notes and                  • Micro-lettering (except in Re.1 and Rs.2),
80.5 gsm in the case of Rs.10 polymer notes with                   • Intaglio printing (in notes of above Rs.10
tolerance limit of +/- 5.0 to 5.5 gsm.                                 denomination),
    Folding Endurance: The notes will show no                      • Demetallic Clear-text Windowed Security Thread,
sign of delamination or surface fracture even after                • Machine readable features,
5000 (in the case of polymer notes 10000) mean                     • Fluorescence ink (mainly in numbers and
double folds under 1 kg tension using an Folding                       Governor’s signature),
Endurance Tester.                                                  • Blink feature,
Security Features                                                  • PEAK (Printed and Embossed Anti-copy Key)
    Different types of security features have been                     feature,
included in the notes of different denominations                   • Anti-photocopy line structure,
issued by the Nepal Rastra Bank. On the basis of                   • See Through Register,
352    NEPAL RASTRA BANK IN FIFTY YEARS

• FIT Medal,                                                            Effort was made to incorporate different security
• STEP (Summary Twin Effect Protection) feature,                    features in the last two decades. However, during
• Iridescent colouring etc.                                         the tenure of two Governor’s Satyandra Pyara
    Of the above-mentioned security features, the                   Shrestha and Tilak Rawal several security features that
conventional (visible) ones and some of the modern                  are difficult to counterfeit have been incorporated
type features like Intaglio, See Through, PEAK are                  using latest available technology. The prominent
easily identified even by the naked eyes in the day-                features are presented below:
light with little bit of human consciousness. Most of                   The notes received by the Rastra Bank if declared
the modern types also known as Intrinsic / Inherent                 counterfeit after detail examinations are forfeited
security features can be detected only with the help                without any compensation to the owner. However,
of advanced technical machines like magnifying lens,                no legal provision exist authorizing the Rastra Bank
STEP watcher, ultra violet light etc. Two of the                    to take action against a person who carries or makes
security features - watermark and security thread are               counterfeit notes. The only action the Bank can initiate
printed in the process of manufacturing the paper                   is to inform the Police authority to file the case with
itself. Other features are printed or embossed                      appropriate court.
afterwards during several stages (normally six) of                      The counterfeit notes so far found in the country
printing. The signature of the Governor and the note                are of bigger denominations (Rs. 500 and Rs. 1000)
numbers including prefix numbers, however, are                      and the technology used for making such notes is
printed at the end.                                                 colour photocopying and computer scanning. As the


  Governor                                          Security Features
  Ganesh Bdr. Thapa       - Crown Watermark
                          - Security Thread
  Hari S. Tripathi        - Crown Watermark
                          - 1.2 mm wide Clear-text Windowed Security Thread
  Satyandra P. Shrestha                             First Series
                          - Crown Watermark
                          - 1.2 mm wide Clear-text Windowed Security Thread
                          - Fluorescence on both sides of note number, signature of the Governor and both sides of Coin
                             Emblem
                          - Machine readable ‘1000’
                                                    Last Series
                          - Portrait Watermark
                          - Size of the Portrait of His Majesty’s the King is big
                          - 2.5 mm wide Clear-text Windowed Security Thread
                           - Fluorescence on both sides of note number, signature of the Governor and Coin Emblem only
                          - Machine readable ‘1000’
                          - PEAK feature
                          - See Through Register
                          - Anti-copy Line Structure
                          - Portrait of the new King
  Tilak Rawal             -   Portrait Watermark
                          -   4 mm wide Clear-text Windowed Security Thread
                          -    Fluorescence on both sides of note number, signature of the Governor and the Crown Plumb
                          -   Machine readable ‘1000’
                          -   PEAK feature
                          -   See Through Register
                          -   Anti-copy Line Structure
                          -   STEP feature
                          -   FIT Medal
                          -   Iridescent coating
  Source: Nepal Rastra Bank
                                                                                       CURRENCY MANAGEMENT         353

task of producing or manufacturing counterfeit                    The price of the gold deposited as security is
currencies is extremely complex, expensive and risky          determined by His Majesty’s Government on the
venture, only notes of bigger denominations have              recommendation of the Bank’s Board and that of
been found to be forged.                                      the price of silver at a rate deemed appropriate by
                                                              the Board. The price of foreign currencies has to be
Nepalese Currency Notes
                                                              in accordance with the exchange rate fixed by the
    As per Section 2, Sub-section (1) of the Nepal
                                                              Bank. Currently, the price of gold has been fixed at
Rastra Bank Act, 2002, ‘Currency note’ is defined as
                                                              Rs. 175 per gram and that of silver at Rs. 3,300 per
the bank note in circulation in the form of cash
                                                              kg. This price was last revised in 1986. In 1957, the
including coins and ‘Nepalese Currency’ as the
                                                              price of gold and silver deposited as security against
currency of Nepalese rupee denominations (Part ‘k’).
                                                              issued notes was valued at Rs. 150 and Rs. 2 per tola
The Rupee is the monetary unit divided in one
                                                              (11.66 gm) respectively.
hundred Paisa (Section 51, Sub- section ‘1’).
                                                                  From the very first year of its establishment the
    Note is a legally acceptable currency within the
                                                              Nepal Rastra Bank continuously followed the practice
Kingdom of Nepal. The notes issued by the Nepal
                                                              of preparing and publishing separate Balance Sheet
Rastra Bank have, on the one hand, guarantee of His
                                                              of the Issue Department. The purpose of separate
Majesty’s Government (Section 51, Sub-section ‘2’)
                                                              balance sheet is to infor m public about the
for the final payment and on the other hand, are
                                                              authenticity, composition and adequacy of assets
issued only after depositing hundred percent security
                                                              deposited as security against the notes in circulation.
in accordance with the theoretical concept of
                                                              The Bank, however, has recently decided to stop this
proportional reserve system. Due to government
                                                              practice of publishing two separate Balance Sheets
guarantee for payment and a hundred percent security
                                                              for the Banking and the Issue Departments from
provision, the general public accepts currency notes
                                                              the Fiscal Year ended on 2004.
as money and uses them as a medium of exchange
                                                                  Prior approval of the His Majesty’s Government
for daily transactions and unit of saved reserve.
                                                              is required for changing the figures, size and
    Although the Rastra Bank has monopoly over
                                                              denominations of the notes, whereas the Board of
the issue of bank notes and coins it can do so only
                                                              the Bank can make changes in invisible security
against the security simply because note issue implies
                                                              features, internal security arrangements and the
increase in Rastra Bank’s monetary liability. With every
                                                              material for printing bank notes.
increase in the quantity of notes issued, the Bank has
                                                                  The Note Exchange Regulations, 1991 classified
to make provision of 100 percent security. Section
                                                              Nepalese currency notes into two categories:
52, Sub-section (2) of the Nepal Rastra Bank Act
                                                              registered and non-registered notes. ‘Registered notes’
2002, has made clear legal provision for the Bank to
                                                              were defined as notes above the denomination of
maintain security deposit while issuing notes. The Act
                                                              Rs.100 and the `non-registered notes’ as notes other
also requires that prior to issuing notes for circulation
                                                              than the registered ones. Before 1991, Rs.100
the Bank has to deposit hundred percent assets as
                                                              denomination note was also classified as registered
security. Security deposit has to be at least fifty percent
                                                              note. The process of destruction, claim
in the form of gold, silver, foreign currency, foreign
                                                              reimbursement and payment of the first category
securities, and foreign bills of exchange and the
                                                              notes was different to that of the second category
remaining percentage in Nepalese coins (Mohar,
                                                              of notes.
Double or coins of higher denominations), debt
                                                                  Over the time, volume of registered notes increased
bond issued by His Majesty’s Government, the
                                                              significantly. As a result heavy pressure was build up to
promissory note or bills of exchange due to be
                                                              the Currency Management Department in managing
redeemed within eighteen months in Nepal from the
                                                              and handling of such notes. The new Note Exchange
date of repayment by the bank.
                                                              Regulations, 2003 and the Note Destruction
    However, with prior approval from His Majesty’s
                                                              Regulations, 2003 do not have provision of categorizing
Government the Bank may issue notes by depositing
                                                              notes into registered and unregistered. Enactment of
a maximum of forty percent back-up by the first
                                                              these regulations automatically led to cancellation of Rs.
category assets and the balance by the second category
                                                              500 and Rs. 1000 denomination as registered notes.
assets.
354     NEPAL RASTRA BANK IN FIFTY YEARS

    Determination of the volume of notes to print                 and to less than 1.0 percent in mid- July 2003 (Table
or to issue is primarily based on factors, such as,               3). Experiencing high printing and management costs
level of monetization, budgetary situation, inflation,            and shorter life-span of smaller denomination notes,
foreign currency reserves, growth in industry and                 Rastra Bank has adopted the policy of stopping
commerce, trend of banking sector savings and                     printing of notes of Re. 1, Rs. 2 and Rs. 5
investments, volume of development expenditure,                   denominations and replacing them with the coins. It
notes in the stock and quantity of notes to be                    is envisaged that this policy would, to some extent,
destroyed that have direct impact on the demand                   increase the proportion of coins in circulation in the
for currency notes in the economy. In addition, the               years to come (Table 3).
past four or five years supply trend is also given due
                                                                  By Denomination
consideration
                                                                      While analyzing composition of different
    Release of notes for circulation is commonly
                                                                  denominations notes in circulation over the years, an
termed as ‘note issue’. In the event of new note issue,
                                                                  increasing trend of bigger denominations is observed.
the common public is informed through notification
                                                                  The proportion of higher denomination notes (Rs.
in the major national news media with description
                                                                  500 and Rs. 1000) which was 73.2 percent of the
of the prominent features including change in the
                                                                  total currency in circulation in mid-July 1993 increased
artwork, size, paper and denominations. However,
                                                                  to 83.9 percent in mid-July 2000 and 86.5 percent in
no public notice is required for reprinted notes. The
                                                                  mid-July 2003 (Table 4). Increases in the proportion
note issue function is performed by the Currency
                                                                  of higher denominations was due to public
Management Department, district offices of the
                                                                  preference, mainly because such notes facilitated
Rastra Bank, and branches of the commercial banks
                                                                  higher value transaction and savings with ease of
that are authorized to operate the Currency Chest.
                                                                  transportation. The Bank, too, has been relieved of
Currency in Circulation                                           the big cost incurred on printing smaller
By Type                                                           denominations notes in huge quantities and also in
    With the increase in circulation of Nepalese                  terms of management and handling (Table 4).
currency, a substantial decrease in the proportion of             By Nature of Account Keeping
coins and increase in the share of notes is observed.
                                                                     The Nepal Rastra Bank has issued notes equivalent
Proportion of coin which was 43.8 percent in mid-
                                                                  to Rs. 165,787.0 million from the stock till the end
July 1960 decreased to 6.5 percent in mid- July 1980
                                                                  of mid-July 2003. Of this, Rs. 77,192.4 million (46.6
 Table 3
 Currency in Circulation : by Type*
 (Rs. in million)
                             Notes                                Coins                       Current in circulation
                              (1)                                  (2)                            (3) = (1)+(2)
                  Amount             Percent         Amount               Percent            Amount           Percent
 1960                 67.6              56.2               52.7              43.8               120.3            100.0
 1965                276.5              87.6               39.1              12.4               315.6            100.0
 1970                522.7              91.9               46.0               8.1               568.7            100.0
 1975                906.4              93.3               64.8               6.7               971.2            100.0
 1980              1,784.4              93.5              124.3               6.5             1,908.7            100.0
 1985              3,865.5              95.8              170.1               4.2             4,035.6            100.0
 1990             10,270.8              97.6              255.6               2.4            10,526.4            100.0
 1995             24,253.5              98.9              278.0               1.1            24,531.5            100.0
 2000             45,258.8              99.1              391.1               0.9            45,650.0            100.0
 2003             61,092.0              99.2              516.5               0.8            61,608.5            100.0
 * Excluding notes and coins held by Nepal Rastra Bank
 Source: Nepal Rastra Bank, Quarterly Economic Bulletin, Mid-October - Mid-January 2004 issue.
                                                                                                  CURRENCY MANAGEMENT        355

 Table 4
 Notes in Circulation : By Denomination* (Mid-July)
 (Rs. in million)
                                   1993                          1996                     2000                     2003
 Denomination          Amount             Percent    Amount         Percent        Amount      Percent      Amount Percent
 1                          91.2              0.5       109.8              0.4        153.1         0.3         175.8      0.3
 2                         102.6              0.6       100.2              0.4        168.5         0.4         213.5      0.3
 5                         223.0              1.3       269.7              1.0        391.0         0.9         457.9      0.7
 10                        463.0              2.6       491.4              1.8        579.8         1.3         847.4      1.4
 20                        334.0              1.9       546.4              2.0        570.5         1.2         764.9      1.2
 25                            -                -           -                -        320.2         0.7         308.6      0.5
 50                        765.0              4.3     1,012.7              3.7      1,184.2         2.6       1,299.6      2.1
 100                     2,780.0             15.6     3,252.6             11.8      4,015.1         8.7       4,232.1      6.8
 250                           -                -           -                -         33.9         0.1          91.8      0.2
 500                     3,900.0             22.0     6,387.9             23.3     10,876.1        23.7      16,162.5     26.1
 1000                    9,100.0             51.2    15,280.8             55.7     27,641.8        60.2      37,420.1     60.4
 Total                  17,758.8            100.0     27,451.5          100.00     45,934.2       100.0      61,974.3     100.0
 * Excluding Old Print Notes.
 Source: Nepal Rastra Bank, Annual Report, different issues.

percent) have been destroyed and notes equivalent                         circulation like other notes. Data presented in Table
to Rs. 61,974.3 million (37.4 percent) are currently in                   6 reveals relatively high consumption of notes of
circulation. An amount equivalent to Rs. 26,620.3                         smaller denominations. However, between mid-July
million (16.0 percent) remains in the Currency Chest                      2000 and mid-July 2003, the number of Rs. 500 and
held by Rastra Bank and the two commercial banks                          Rs. 1000 denomination notes issued from the stock
(Table 5).                                                                increased significantly by 71.3 and 60.5 percent
                                                                          respectively (Table 6).
 Table 5                                                                  Security Against Note Issue
 Notes in Circulation* (Mid-July 2003)                                       Gold worth Rs. 831.7 million, silver worth Rs.
 (Rs. in million)                                                         459.3 million, His Majesty’s Government Bonds
 1.      Notes Issued from the Stock                                      worth Rs. 4,172.0 million and the remaining in foreign
        (Cumulative )                               165,787.0             currency and foreign securities were deposited as
 2.      Notes in Currency Chest {(a)+(b)}           26,620.3             security against the notes issued till mid-July 2003.
        (a) With Nepal Rastra Bank                   25,488.0
                                                                          An analysis of the composition of the assets
         (b) With Commercial Banks                    1,132.3
 3.      Notes Destroyed (Cumulative )               77,192.4             deposited as security of the notes issued over 1993-
 4.      Notes in Circulation [(1)-{(2)+(3 )}]       61,974.3             2003 period shows proportion of gold, silver, and
 * Excluding Old Print Notes.
                                                                          foreign currency and securities higher than 84 percent.
  Source: Nepal Rastra Bank                                               There is no change in the amount of gold and silver
                                                                          deposited as security since 1993 (Table7).
   The maximum number of notes issued from the                            Per Capita Notes in Circulation
stock till mid- July 2003 was of Re.1 denomination
                                                                             After the Rastra Bank started issuing notes and
(648.5 million pieces). Similarly, the lowest quantity
                                                                          made arrangements for the Currency Chests, the per
of notes issued was that of Rs. 250 denomination
                                                                          capita notes in circulation increased from Rs. 4.3
(only 0.5 million pieces). Initially, Rs. 250
denomination note was issued along with artistic                          million in 1957 to Rs.138.8 million in 1981 and Rs.
folder as commemorative note. But since a large                           2473.4 million in 2003. Such an increase in the per
quantity of such notes were lying idle in Bank’s vault                    capita notes in circulation has helped to transform
it was decided in 2000 to put those notes in                              the subsistence Nepalese economy into a market
356     NEPAL RASTRA BANK IN FIFTY YEARS

 Table 6
  Note Issued from the Stock (Cumulative): by Denomination*
 (In number)
 Denomination                              Mid-July 2000               Mid-July 2003                Change (%)
 1                                            601,479,612                   648,580,594                          7.8
 2                                            263,664,156                   312,165,156                         18.4
 5                                            424,155,516                   494,256,529                         16.5
 10                                           432,538,033                   519,038,865                         20.0
 20                                           143,308,766                   187,909,742                         31.1
 25                                            25,149,804                    39,999,786                         59.0
 50                                           123,573,650                   156,825,591                         26.9
 100                                          177,308,716                   227,297,941                         28.2
 250                                              249,820                       499,820                        100.1
 500                                           48,366,628                    82,865,171                         71.3
 1000                                          49,818,029                    79,965,620                         60.5
 Total Value (in Rs.)                     109,043,238,354               165,787,005,841                         52.0

 * New Print Notes.
 Source: Nepal Rastra Bank


 Table 7
 Security Against Note Issue
 (Rs. in million)
                                                                                                   Percentage of
                               Foreign                                                               Foreign
                              Currency                                               Security     Exchange and
                                 and                                    HMG          of Note      Gold and Silver
          Gold      Silver    Securities         Total        Coins     Bonds        Issued*     in Total Security
           (1)          (2)      (3)        (4)=(1)+(2)+(3)    (5)        (6)             (7)    (8)=(4)/(7)x100
 1993     831.7       459.3    13,682.1         14,973.1      22.6      2,670.0      17,665.7           84.8
 1995     831.7       459.3    23,248.1         24,539.1      22.6         -         24,561.7           99.9
 1997     831.7       459.3    26,116.0         27,407.0      22.6      2,620.4      30,050.0           91.2
 1999     831.7       459.3    34,606.0         35,897.0      22.6      2,620.4      38,540.0           93.1
 2001     831.7       459.3    51,536.4         52,827.4      22.6         -         52,850.0           99.9
 2003     831.7       459.3    56,517.0         57,808.0       -        4,172.0      61,980.0           93.6
 * Including notes equivalent to Rs.5.8 million issued by Sadar Mulukikhana (Old Print Notes).
 Source: Nepal Rastra Bank, Annual Report, different issues.

economy and to enhance the level of monetization.              coating during latter half of the tenure of Governor
Details of per capita notes in circulation are presented       Tilak Rawal. The high cost of Rs. 10 denomination
in table 8 below.                                              reflects the cost of printing newly introduced
Average Printing Cost                                          Polymer notes. Another reason for such a big
   Per unit printing costs incurred by denomination            increase in the cost structure is the inclusion of the
incurred in 2000 and 2004 are presented in table 9.            cost of clearing and forwarding of notes from the
The printing cost of higher denomination notes in              Kolkata Port to Kathmandu and travel and other
2004 has increased by more than 130.0 percent                  direct expenses incurred, whereas the cost in the
mainly due to the addition of more costly security             year 2000 included only the C.I.F. Kolkata price of
features like STEP feature, FIT Medal and Iridescent           note printing (Table 9).
                                                                                               CURRENCY MANAGEMENT          357

 Table 8                                                             basically implies the task of preparing framework
 Per Capita Notes in Circulation*                                    of the notes to be printed. During the preparation
 (Rs. in million)                                                    of the specimen note special attention is paid to the
                                                                     denomination, colour, shape, type, size, etc of the
                Population            Notes in          Per Capita
 Mid-July       (in millon)        Circulation*             Notes    note. Similarly, artwork, artistic design and figures
 1957                      9.3                39.7             4.3
                                                                     that provide Nepalese identity in terms of royal
 1961                      9.4               107.8            11.5   institution, religion, art, culture, natural resources,
 1971                     11.6               563.2            48.6   wildlife are selected.
 1981                     15.0             2,082.2           138.8
 1991                     18.5            12,348.7           667.5       Apart from different colour and size of notes,
 2001                     23.2            51,980.6         2,241.0   pictures, animals, temples and mountain are so chosen
 2003                     24.7            61,092.0         2,473.4
                                                                     that even the illiterate public will also find no difficulty
 * Excludes notes held by Nepal Rastra Bank.                         in identifying notes of different denominations.
 Source: Nepal Rastra Bank.
                                                                         Of the notes currently in circulation, the green-
                                                                     coloured Rs. 100 note, the highest denomination note
                                                                     until 1969, has the picture of one-horned rhinoceros,
  Table 9
                                                                     found in the Char Koshe (thick terai) jungles. Such a
  Average Printing Cost of Notes: By
                                                                     unique picture has enabled even the illiterate public
  Denomination*
                                                                     to conduct economic transactions with Rs. 100
  (In Rs.)
                                                                     denomination notes without any difficulty.
                         Per Unit Cost
                                                                         After 1969, the highest denomination note in
                 2000                    2004        Change (%)      circulation is of Rs. 1000. The logic behind the
  1               0.76                      -                  -     selection of an elephant for this note was that it carries
  2               1.06                      -                  -
                                                                     a value equivalent to donation of one of the biggest
  5               1.10                   1.73               57.3
  10              1.26                   3.28              160.3     animal, an elephant. Similarly, a Rs. 50 denomination
  20              1.58                   2.34               48.1     note carries a black- buck. Other notes carry picture
  50              1.94                   3.16               62.9
  100             2.12                   5.13              142.0
                                                                     of viharas, temples, stupas and idols built in different
  500             3.10                   7.18              131.6     regions of Nepal.
  1000            3.39                   7.82              130.7         A Note Design Committee with Governor as
  * Estimate.                                                        chair pursuant to Section 10 of the Nepal Rastra
                                                                     Bank Note and Coins Regulations, 2003 is in place.
  Source: Nepal Rastra Bank.
                                                                     Other members of the Committee are two Deputy
                                                                     Governors, some senior officials of the Nepal Rastra
    Though the unit cost of printing smaller
                                                                     Bank, prominent personalities such as linguist,
denominations notes looks lower in comparison to
                                                                     archeologist, historian, wildlife expert, etc. This
that of notes of bigger denominations, they are in
                                                                     Committee prepares detail design of the notes of
fact more expensive due to lower durability and
                                                                     different denominations to be printed and submits
higher management expenditure. The age of notes
                                                                     the blue print along with its recommendation to the
of Re. 1, Rs. 2 and Rs. 5 denominations is less than
                                                                     Board. Such design after endorsement by the Board
six months as against three years of Rs. 500 and Rs.
                                                                     is presented to His Majesty’s Government for
1000 denominations notes. This ageing, however, is
                                                                     approval.
estimated only on the basis of experience and not
on systematic evaluation. In view of the fact that the               Printing
notes of smaller denominations are more expensive                        After the design of the note is approved by the
from the cost viewpoint, Rastra Bank has adopted                     government, printing phase begins. In the absence
the policy of stopping their printing and gradually                  of high quality security press in the country notes are
replacing them with coins.                                           being printed by reputed security printers selected
                                                                     through global tender from among pre-qualified
Note Design                                                          companies.
   The primary stage in the manufacturing process                        For the purpose of preparing pre-qualification
of notes is “designing of notes”. Note designing                     list of security printers, Bank invites global tender
358    NEPAL RASTRA BANK IN FIFTY YEARS

through advertisement in major national and                defective notes. If defective notes are issued by
international newspapers. Bank then prepares pre-          mistake, it not only creates unnecessary confusion
qualification list of selected companies on the basis      among the public but also lowers Bank’s prestige
of credibility, size of transactions, experience,          and public confidence. Notes with the following
technology, security features and reputation in the        defects are discarded during verification:
global market. The current pre-qualification list, which   • With any blot print in the face of His Majesty.
was prepared in 2002 includes the following ten            • Without note number including prefix number.
Security Printers :                                        • Without the signature of the Governor.
• Giesecke & Devrient GMBH, Germany                        • With unclear numerical letters.
• De La Rue Currency, U. K.                                • With Governor’s signature and note number in
• Real Case De La Moneda, Spain                               wrong places.
• Oebs Banknoten, Bank Australia                           • With boarder cuttings not conforming with
• Francois- Charles Oberthur Fiduciare, Paris,                specified tolerance limit.
    France                                                 • With artwork and design not in confirmation with
• Joh Enschede Security Print, Int. Div., England             specimen.
• Bundes Druckeri GMBH, Berlin, Germany                    • With different note numbers or note number on
• Orell Fuessli, Switzerland                                  both sides.
• Polska Wytwornia, Warszawa, Poland                       • Printed on wrinkled paper.
• Perum Peruri, Indonesia                                  • Printed on one side only.
    The Bank invites tenders for printing the notes        • Letter, design, pictures depicted on one side are
only from those pre-qualified security printers who           also visible from the other side.
have been selected through the global tender.                 Notes found defective during verification are
    Rastra Bank has constituted a Work Management          stored separately in a vault. Such notes are destroyed
Committee with chief of the Currency Management            upon receipt of reimbursement of such notes with
Department as coordinator. The responsibilities of         ten percent penalty over the printing cost from the
the Committee includes: preparation of tender form,        printing company
tender, invitation letter, agreement letter and the note
                                                           Note Destruction
specifications as prescribed by the Note Design
                                                               Notes become soiled as they change hands in the
Committee. The Committee is also responsible for
                                                           course of economic transactions. Issued notes are
post tender activities such as opening and evaluation
                                                           returned back by the Bank in torn, burnt, decayed,
of tenders submitted by the security printers and
                                                           defaced, soiled or fragmented conditions. The process
submitting its report and recommendations to the
                                                           of powdering such notes including those identified
Governor. Upon approval from the appropriate
                                                           as unsuitable for reissue is known as “note
authority the Currency Management Department
                                                           destruction”.
makes necessary arrangements for printing the notes
                                                               After the enactment of the present Nepal Rastra
by concluding an agreement with the company
                                                           Bank Note Destruction Regulations, 2003, the notes
concerned.
                                                           are destroyed by incineration or shredding. Prior to
Verification                                               that, the notes had to be destroyed by incinerating
    Prior to issuance of any denomination notes            only. The provision of shredding was incorporated
Rastra Bank examines the suitability for their release     in the present regulation after the issuance of polymer
from different perspectives. The process of                notes. Polymer notes are destroyed by shredding and
examining whether or not the notes printed by the          other paper notes by burning.
company match with specimen and specifications and             Currently, the notes segregated for destruction are
segregating good and defective notes is called ‘note       destroyed either by incineration in the furnace or by
verification’. Notes not complying with specimen           shredding in the presence of the representatives of
and specification are called ‘defective’ notes.            the concerned agencies. Before destruction, notes are
    As note verification is an extremely sensitive and     counted and punched (two punches in notes of
critical task, the Bank is always alert to see that the    below Rs. 50 denomination and four punches in
notes identified as good ones are not mixed with           notes of Rs. 50 and higher denominations). Defective
                                                                                                      CURRENCY MANAGEMENT        359

notes and notes under claim are not required to be                             • facilitate authorized commercial banks for
punched.                                                                           smooth conduction of government transaction
    The task of note destruction was initiated by the                              and,
Bank only after the enforcement of the Nepal Rastra                            • withdraw worn, torn and soiled notes from
Bank (Note Destruction) Regulations, 1961. By mid-                                 circulation and issue fresh ones.
July 2003, Nepal Rastra Bank had destroyed notes                                   The setting up of Currency Chest was initiated
of different denominations equivalent to Rs. 77,192.4                          from April 7, 1960 onwards. Currently, Currency
million, which is 46.6 percent of total issued notes                           Chests are operated by eight offices of Nepal Rastra
of Rs. 165,787.0 million (Table 10).                                           Bank, forty-three offices of Rastriya Banijya Bank
                                                                               and twenty offices of Nepal Bank Ltd.
 Table 10
                                                                                   The onus of operating the Currency Chests is
 Note Destruction*
                                                                               that of the offices of commercial banks concerned.
 (In Rs.)
                                                                               The responsibility of making arrangements for
 Denomination     Notes Issued      Notes Destroyed     Percentage of
                                                         Destruction
                                                                               adequate and timely supply of money required by
                                                                               the Currency Chests, however, rests with Rastra Bank.
 Mid-July 2000   109,043,238,354       41,421,043,674            38.0          The Bank does so through the mechanism of fund
 Mid-July 2003   165,787,005,841       77,192,413,772            46.6
                                                                               transfer. Rastra Bank also makes arrangement for the
 * New Print Notes.                                                            insurance of money kept in Currency Chest at its
 Source: Nepal Rastra Bank.
                                                                               own cost.
   In terms of pieces, the proportion of destruction                               The amount in the Currency Chests is the assets
was higher for notes below Rs. 50 denomination                                 of Rastra Bank. Commercial banks are, therefore,
(Table 11).                                                                    required to follow the procedures and directives set
                                                                               by the Rastra Bank, while operating the Chest. The
Currency Chest                                                                 offices who operate Currency Chest are required to
  The principal objectives behind establishing the                             inform Rastra Bank details of the withdrawals/
Currency Chest are to:                                                         deposits transactions conducted through the Chest
• promote circulation of the Nepalese currency,                                on the same day. Moreover, the operators of the
• expand the pace of monetization,                                             Chest can withdraw from or deposit to the Chest at

 Table 11
 Details of Note Destruction*
 (In pieces of notes)
                                   Notes Issued                                Notes Destroyed                 Percentage of
                                                                                                               Descruction
 Denomination Mid-July 2000                  Mid-July 2003              Mid-July 2000    Mid-July 2003         2000          2003
 1                      601,479,612              648,580,594              436,058,941       469,422,813         72.5           72.4
 2                      263,664,156              312,165,156              168,263,409       200,388,492         63.8           64.2
 5                      424,155,516              494,256,529              323,776,040       399,194,358         76.3           80.8
 10                     432,538,033              519,038,865              357,547,434       424,362,502         82.7           81.8
 20                     143,308,766              187,909,742              102,416,670       141,699,502         71.5           75.4
 25                      25,149,804               39,999,786                5,079,147        24,027,460         20.2           60.1
 50                     123,573,650              156,825,591               87,531,205       124,307,099         70.8           79.3
 100                    177,308,716              227,297,941              120,627,073       174,705,650         68.0           76.9
 250                        249,820                  499,820                        5            10,501          0.0            2.1
 500                     48,366,628               82,865,171               11,554,092        28,322,795         23.9           34.2
 1000                    49,818,029               79,965,620               11,062,377        28,797,998         22.2           36.0

 * New Print Notes.
 Source: Nepal Rastra Bank.
360    NEPAL RASTRA BANK IN FIFTY YEARS

a multiple of Rs. 50 thousand at a time. Similarly,       printing notes abroad, incur heavy miscellaneous
the operators can deposit or withdraw in bundle of        expenses in Indian currency for transporting notes
1000 pieces of any denomination. In such events,          from Kolkata to Kathmandu and also in Nepalese
the concerned bank branches should keep the money         currency for distributing them from kathmandu to
belonging to the Currency Chest separately without        other parts of the kingdom. One may suggest that
mixing it with the money generated from their regular     establishment of security printing press within the
banking transactions.                                     country would save a huge amount of foreign
    Remittance expenses presented in table 12 shows       currency and avoid unnecessary hassles in transporting
a substantial increase in fund transfer cost during       notes as well as cut down the management costs.
1999-2003 period. Fund transfer expenses, which           However, whether the huge investment needed for
was Rs. 43.2 million in 1999 increased drastically to     the establishment of note printing security press is
Rs. 94.0 million by mid- July 2003. Transfer of fund      affordable / justifiable or the country has the ability
by the nearest Rastra Bank office to the currency chest   of operating such press at profit is a debate. In
used to be made normally by road transport. Places        author’s view, it needs a through and in-depth study
not connected by fair road network were supplied          before any decision is taken on this issue.
funds through air transport. However, with the                (iii)Though the Nepal Rastra Bank has adopted
worsening security situation in the country the fund      the FIFO (First In First Out) type inventory
has to be transported through air transport in almost     management policy in theory, this has not been
all places resulting in a substantial rise in the fund    effectively practiced in respect of note issue. Large
transfer expenses.                                        volume of notes of different denominations printed
                                                          during the tenure of ex- governors are still found to
 Table 12                                                 be lying in the stock, while the notes printed during
 Remittance Expenses                                      the officiating Governor are in extensive circulation.
 (Rs. in million )                                            (iv)Nepal Rastra Bank has already adopted the
      Mid-July        Fund Transfer       Change          policy of replacing small denomination notes by
                        Expenses           (%)            coins, but has not been able to supply the coins
                                                          adequately.
        1999               43.2              -
        2000               51.3             18.7              (v) In view of the large volume of notes being
        2001               58.4             13.8          issued by the Bank every year an utmost need exist
        2002               82.3             40.9          for enhancing modernization process in the areas of
        2003               94.0             14.2          counting, sorting, verification and destruction of
                                                          notes.
 Source: Nepal Rastra Bank.
                                                          Conclusion
                                                              The beginning of Nepalese monetary system dates
Challenges/Problems                                       back to the minting of the ‘manank’ coins during
    (i) Central Banks all around the world are facing
                                                          the Lichhivi period. It took a great leap forward in
two major challenges regarding currency
                                                          1945 when the Sadar Mulukikhana started issuing
management: (a) achieving notes printing and issuing
                                                          paper currency notes. Nepal Rastra Bank, the sole
activities more cost- effective, and (ii) addressing
                                                          monetary authority for managing the issue and
incidence of counterfeits. There are many instances
                                                          circulation of the Nepalese currency, started printing
of attempts made by central banks to address these
                                                          and issuing the currency notes from February 19, 1960.
two fundamental questions. Most have been
                                                              The Nepalese currency was made the only legal
successful greatly in addressing counterfeiting issues
                                                          tender currency all over the Kingdom by 1967. The
by introducing additional security features but have
                                                          Nepal Rastra Bank Act, 2002 defines ‘Currency
achieved less success in addressing the cost issue. The
                                                          notes’ as the bank note in circulation in the form of
same is true for Nepal Rastra Bank.                       cash including coins and ‘Nepalese Currency’ as
    (ii) Until now, the Bank has been printing notes      the currency of Nepalese rupee denomination. The
from security printers located abroad. The country        ‘Rupee’ is the monetary unit divided in one hundred
has to spend large amount of hard currency for            ‘Paisa’.
                                                                                     CURRENCY MANAGEMENT        361

    Over the twelve different Governor’s tenures              (46.6 percent) have been destroyed and notes
notes of eleven denominations ranging from rupee              equivalent to Rs. 61,974.3 million (37.4 percent) are
one to thousand came in circulation. Polymer notes            in circulation. The proportion of higher
were first introduced in 2002.                                denomination notes in total currency in circulation
    Nepalese currency notes are printed in paper made         was 86.5 percent in mid- July 2003. However, the
out of cotton or polymer substrate. In the last decade,       maximum number of notes issued from the stock
several security features using latest technology like        till mid- July 2003 was of Re. 1 denomination (648.5
STEP feature, FIT Medal, Iridescent coating, PEAK             million pieces), which reveals relatively high
feature, Anti Copy Line Structure have been                   consumption of notes of smaller denominations.
incorporated in the notes of higher denominations.                 The Currency Chests operated by Nepal Rastra
This has led to a big increase in the cost of printing        Bank and authorized commercial bank branches in
notes. The printing cost of higher denomination notes         seventy-one places are the main channels of issuing
in 2004 has increased by more than 130.0 percent              notes.
over the printing cost of 2000.                                    Experiencing high printing and management costs
    The notes are being printed by reputed security           and shorter life-span of smaller denomination notes,
printers from among pre-qualified companies that              Rastra Bank has adopted the policy of stopping
are selected through global tender. The current pre-          printing of notes of Re.1, Rs. 2 and Rs. 5
qualification list includes 10 security printers mainly       denominations and replacing them with the coins.
from the Europe.                                              The age of notes of Re. 1, Rs. 2 and Rs. 5
    While printing notes, prior approval of the His           denominations is less than six months as against three
Majesty’s Government is required for changing the             years of Rs. 500 and Rs. 1000 denominations notes.
figures, size and denominations of the notes, whereas              The torn, defaced and soiled notes are destroyed
the Board of the Bank can make changes in invisible           by incineration or shredding. The provision of
security features, internal security arrangements and         shredding was incorporated in the appropriate
the material for printing bank notes.                         regulation after the issuance of polymer notes.
    During the process of note design, special                     Despite numerous constraints Rastra Bank has
attention is paid to the denomination, colour, shape,         been trying its best in discharging its currency
type, size, etc of the note. Similarly, artwork, artistic     management role. To the Rastra Bank, there still exist
design and figures that provide Nepalese identity in          challenges like rising printing cost, frequent
terms of royal institution, religion, art, culture, natural   counterfeiting, increased fund transfer expenses,
resources, wildlife are selected.                             dearth of technical expertise, lack of note printing
    The Rastra Bank, despite monopoly over the issue          manual, lack of effective FIFO system of inventory
of bank notes, can do so only after maintaining 100           management and inadequate mechanization. Such
percent security- at least fifty percent in the form of       challenges need to be tackled and streamlined through
gold, silver, foreign currency and foreign securities,        the adoption of appropriate policies and procedures.
and the remaining percentage in Nepalese coins and
                                                              Bibliography
Nepalese securities. In practice, the proportion of
                                                              Jha, Jai Hari, (2001), Nepalese Paper Currency- An
the first category assets constitute about 94 percent
                                                                 Assessment, Manjit Jha, Lalitpur (In Nepali).
of total assets deposited as security against note issue.
                                                              Nepal Rastra Bank, (1971), Nepal Rastra Bank - An
Currently, the price of gold and silver deposited as
                                                                 Introduction, Nepal Rastra Bank, Kathmandu (In
security is fixed at Rs. 175 per gm and Rs. 3,300 per
                                                                 Nepali).
kg respectively.
                                                              Nepal Rastra Bank, (1981), Twenty-fiveYears of
    The Sadar Mulukikhana had issued a total of Rs.
                                                                 Nepal Rastra Bank, (1956-1981), Nepal Rastra
54.9 million from September 17, 1945 onwards of
                                                                 Bank, Kathmandu (In Nepali).
which, notes of Rs. 39.7 million were in circulation
                                                              Nepal Bank Ltd., (1987), Golden Jubilee Souvenir,
as of mid- July 15, 1957. Beginning the date Nepal
                                                                 Nepal Bank Ltd., Kathmandu (In Nepali).
Rastra Bank started issuing notes the Bank issued
                                                              Nepal Rastra Bank, (1996), 40 Years of the Nepal
notes equivalent to Rs. 165,787.0 million from the
                                                                 Rastra Bank 1956 –1996, Nepal Rastra Bank,
stock until mid-July 2003. Of this, Rs. 77,192.4 million
                                                                 Kathmandu
362   NEPAL RASTRA BANK IN FIFTY YEARS

Nepal, Vishnu, (1999), Some Issues on Counting,     Nepal Rastra Bank, Quarterly Economic Bulletin,
  Sorting, Verification and Issue of Notes,            various issues.
  Prashikchhyan, Nepal Rastra Bank, Kathmandu.      Nepal Rastra Bank, Annual Report, various issues.
Nepal Rastra Bank Act, 2002                         Nepal Rastra Bank, Economic Report, various issues.
                                                    Paudel, Mukunda, (2004), Security Features of Notes
Nepal Rastra Bank Note Destruction Regulations,
                                                       and Identification of Counterfeit Notes,
  2003
                                                       Samacher, Nepal Rastra Bank, Kathmandu (In
Nepal Rastra Bank Note Exchange Regulations, 2003
                                                       Nepali).
Nepal Rastra Bank Note and Coins Regulations,       Rastriya Banijya Bank, (1991), Silver Jubilee Souvenir,
  2003                                                 Rastriya Banijya Bank, Kathmandu (In Nepali).
                                                                            DOMESTIC DEBT MANAGEMENT         363




                          Domestic Debt Management
                                             Gokul Ram Thapa
                                 Director, Public Debt Management Department
Introduction                                                          thinks that borrowing is not at all useful
    Domestic debt is one of the                                       for national development. Some schools
components of public debt, which                                      are expressing their views that only after
consists of both domestic debt and                                    the detailed impact study on economy of
external debt. We have the different                                  the borrowing, the government has to
definitions of domestic debt like “ it is                             borrow. This second concept is more
the debt denominated in local currency”                               important for those countries, which are
or “it is the money borrowed by the                                   in the stage of infrastructure
government in local currency,” “domestic                              development.
debt is the loan enjoyed by the state in                                    The government announces its
local currency” etc. By these definitions, we can say     policy and programs annually through the budget.
that the domestic debt is the money borrowed by           In the budget, the government also announces the
the government (the government may be of any              projects to be implemented and the required
form like state government, central government or         expenditure for the implementation and completion
it may be federal government) and that the borrowed       of such projects.
money will be in local currencies .In domestic                The targeted projects should be completed during
borrowing the debtor will be the government itself        the prescribed period. For this, the government has
and the lender may be the individuals or the              to make the required resources available for on-going
institutions. In public borrowing, the government         and for proposed projects. The required expenditure
provides some guarantee to the lenders by issuing         for the project has to be met by the government
the security papers in the form of certificates. It       through revenue or from borrowing. It is the regular
may be a bond certificate or a bill certificate.          phenomena of the developing country that every
                                                          time the government expenditure supersedes its
Concepts of Domestic Borrowing                            income, the situation of deficit of resources may
   Till the 3rd decade of the 20th century, the concept   exist. That deficit may be for the shorter period or it
of government borrowing had not emerged and
                                                          may be for the longer duration (for the whole financial
people were thinking that borrowing by the
                                                          year). During this period also the government cannot
government was the misuse of the resources. During
                                                          stop the ongoing projects in the country. In such a
1930 (economic depression period) the concept of
deficit financing and use of idle resources emerged.      situation, the government fulfills its needed
Keynes was the founder personality of this concept.       expenditure through other sources like borrowing.
There are still two schools of thought. One school        The sources of borrowing may be the internal
364    NEPAL RASTRA BANK IN FIFTY YEARS

borrowing or external borrowing or both. But the            bank should share an understanding of the objective
external borrowing may not be so reliable. So, the          of the debt management. The debt manager should
government may choose the most dependable source            convey their views to the fiscal authorities on the cost
of deficit financing, viz., domestic borrowing. In          and risk associated with government financing,
this paper, the discussion will be focused on domestic      requirements of government financing and the debt
borrowing and its management in Nepal.                      levels. Also, the debt manager should share the
                                                            information on the government’s current and future
Principle of Domestic Debt Management
                                                            liquidity needs.
    Internal portfolio is the largest financial portfolio
                                                                The management of debt includes many
in the country. It has a big role to play for financial
                                                            functions like planning of debt, issuing the different
stability in the country and it may create a risk to the
                                                            borrowing instruments, conduct of primary and
government’s balance sheet. Hence, it has got an
                                                            secondary market of the government securities, public
important role in the government’s fiscal management
                                                            awareness program, roll-over and payment of debt.
system.
                                                            But the main objective of the debt management
    The debt management is the process of
                                                            should be concentrated and well specified in terms
establishing and executing a strategy for managing
                                                            of cost and risk involved in the borrowing. Efficient
the government’s debt. The objective of the
                                                            domestic capital market is an essential pre-requisite
management should be to raise the required amount
                                                            to strengthen the government security market. In
of funding, to minimize its risk and cost objective,
                                                            some countries the debt is managed by establishing
to meet any other sovereign debt management goal,
                                                            an autonomous debt management office. In Nepal,
and to maintain an efficient market for government
                                                            the Nepal Rastra Bank (NRB), the central bank of
securities. So, the debt manager should be aware of
                                                            the country, is the domestic debt manager of the
the impact of government financing, requirement of
                                                            government.
government financing and the cost of borrowing
on debt. To know whether the borrowing is                   Why Does the Government Borrow?
sustainable or not, the debt manager should also                There may be the situation of the expenditure
visualize some important indicators like public sector      exceeding income for a short period or for the
debt service ratio, ratio of public debt to GDP and         longer duration; in such a situation, the deficit of
ratio of public debt to revenue, ratio of development       resources exists for the government. When the
expenditure to GDP, ratio of budget deficit to              estimated expenditure exceeds the revenue or the
domestic borrowing, etc. The debt manager should            estimated revenue is less than the expenditure, the
also consider the maturity of the debt structure,           government may go for domestic borrowing to
crowding- out and roll over on the borrowing; then          meet the shortfall by issuing borrowing instruments
only we can say that the debt is well managed and           like treasury bills for a short term period and bonds
well structured. If we do not consider all this while       for a long term period. The government does not
borrowing the debt it is considered as poorly               borrow from the public all the time; in general, in a
managed.                                                    situation when its treasury position goes short, the
    There are many risks involved like interest risk,       government will bor row. Sometimes the
roll over risk, settlement risk, operational risk and so    government borrows largely to meet the country ‘s
on. So, one of the important objectives of the debt         emergency situation like war, famine, etc. when it
management should be to minimize the risks. The             feels the difficulty to finance for the extended
risk of borrowing can be minimized by adopting              activities
techniques like increasing the maturity period of               The government sometimes may borrow from
borrowing, deferring payment of higher rate security,       its cash surplus position also. The objective of such
making payment of higher rate securities by                 borrowing is to speed up the economic activities in
borrowing shorter duration securities on the basis          the country. Such burrowing will be used in financing
of projected yield curve slop.                              development activities; especially, when the
    Debt management is also the coordination                unemployment rate goes up, the government may
between the monetary and fiscal policy of the country.      increase the borrowing amount to improve the
The debt manager, fiscal policy advisor, and central        situation.
                                                                                DOMESTIC DEBT MANAGEMENT          365

    Though the government always tries to meet its              transportation and so on. This leads to an increase
regular expenditure and maximum portion of                      in the economic activities of the country.
development expenditure through its revenue but due        2.   The government borrows the money by paying
to the increasing trends in regular expenditure, total          reasonable interest rate and discount rate for the
expenditure requirement is bigger than government               borrowed amount as incentives for the investors.
revenue, and there will be a saving-investment gap.        3.   Collection of resources from the large number
In such a situation, the development expenditure of             of the small savers: When the government
the country should be met by the external and internal          announces the borrowing scheme, a large number
borrowing sources.                                              of the citizens will be ready to invest on the
    When the expenditure is equal to the total revenue          government securities. It is an opportunity for the
of the country, the borrowing may not be needed.                small investors and small savers.
However, frequently the balance situation does not         4.   Collection of excess reserve from the banks and
exist especially in the developing country like ours            financial institutions: There may be a good amount
.The estimation of deficit budget is a normal process           of excess liquidity with the bank and financial
in many countries. The estimation of deficit budget             institutions. This liquidity is the amount deposited
may be a good intention, because many economists                by the public in the banks and deposit-taking
viewed that the deficit budget is an essential condition        institutions. They have to pay an interest on deposit
to speed up the economic development of the                     even if they are unused. If this excess amount of
country. This deficit budget situation will force the           money is not invested, the banks cannot pay the
government to borrow. When the government                       interest to the depositors. To motivate the people
borrows, it will be invested in the productive and              to deposit and save, the government has to mop
developmental activities in the country. This will lead         up the excess liquidity by borrowing. So, the
to an increase in the economic activities and ultimately        borrowing can be a good motivating tool for
to an increase in income, saving and investment level.          the depositors.
    The government borrows by issuing different            5.     It helps the commercial banks and financial
borrowing instruments having different characters               institutions to deploy their idle resources; it also
and targeting to different individuals and institutions.        helps them to reduce the cost of liquidity.
These borrowing instruments are known as the               6.   To achieve the target of monetary policy: The
government securities papers. These instruments are             general target of the monetary policy may be the
guaranteed papers or agreement paper issued by the              areas like price stability, exchange rate stability,
government against the borrowing amount.                        money supply, inflation control, interest rate
                                                                stability, etc. There will be a great distortion in the
Advantages of Domestic Borrowing
                                                                economy if these monetary policy targets are not
       Though some people think that government
                                                                achieved. So, to achieve the aggregate monetary
borrows when it is in crisis and is lacking resources,
                                                                target, the domestic borrowing could be an
this is true to some extent but is not true always.
                                                                effective tool.
Some time it is essential to borrow even if the
                                                           7.   To fulfill the resource gap for development
government is in comfortable treasury position. The
                                                                activities of the government: The ongoing
government borrows to invest in the development
                                                                projects of the government should not stop due
projects. So, there are many advantages of domestic
                                                                to the resource constraints and should be
borrowing. They are listed below:
                                                                completed in time. The halting of the ongoing
1. Collection of unused resources and using it on
                                                                projects and postponement of the pipeline
    productive sectors: The small portion of the
                                                                projects is possible when the government
    money held by the people and institutions may
                                                                expenditure exceeds the income, or when the
    not be used or they may be insignificant for
                                                                government revenue collection is not as expected.
    investment in the projects. When the government
                                                                Thus, to avoid the resource gap problem, the
    announces the borrowing program they can invest
                                                                government can finance and make fund available
    in the government securities and these collected
                                                                through domestic borrowing.
    money will be sufficient to be invested on big
                                                           8.   To mop up the excess liquidity from the economy:
    projects like irrigation, road construction, and
                                                                There should be an optimum level of liquidity
366   NEPAL RASTRA BANK IN FIFTY YEARS

   reserve in the economy. Higher and lower than         1) When the government borrows an excess
   required level of liquidity is not desirable for          amount, the possibility of undertaking unjustifiable
   economic stability. Excess liquidity will have an         projects by the government will be increased.
   adverse impact on inflation, interest rate or cost    2) Internal borrowing implies the easy money being
   of production and ultimately it will hinder the           available to the government. By excess borrowing
   economic development process. So, if the liquidity        the government may have the tendency of
   is higher than the desirable level, it has to drain       spending on non-productive and non-feasible
   from the system .To minimize this spillover effect        sectors. In such a situation the full burden of the
   and maintain monetar y stability, domestic                debt will be postponed and the interest rate
   borrowing can help. Through domestic                      burden on government will go up unnecessarily
   borrowing, liquidity will be drained from the             which will lead to increase in interest rate and
   system. Borrowing by issuing government                   money will be diverted from private enterprises
   securities could be a very effective tool to keep         to government security. Finally, this may result in
   the excess liquidity at the proper level.                 the government depreciating its currency and
9. To develop an infrastructure in the country:              defaulting on its obligations.
   Infrastructure development is very essential for       3) The government securities are the risk-free areas
   national development. Infrastructure development          of investment. Banks will try to invest on these
   sectors like education, health ser vices,                 risk- free areas; but there may be lack of private
   transportation, communication and irrigation              finance in the productive sectors due to the lack
   needs a substantial amount of expenditure. This           of resources. Thus, internal borrowing may
   deficit level of expenditure can be recovered             affect private financing.
   through borrowing. Internal borrowing could be         4) By borrowing for the longer period, the
   a reliable source for deficit financing for these         government tends to postpone its payment. This
   sectors.                                                  will shift the liability to future generations.
10 It is used as debt servicing instruments: During          Borrowing could increase the debt burden for
   the recession period also the government has to           the future generations. Likewise, if the government
   make payment of principal and interest to the             borrows beyond its repaying capacity, the debt
   foreign loan as well as to domestic borrowing.            trap possibility will be increased.
   Thus, the government can collect resources by         5) It is widely accepted that the productivity of the
   domestic borrowing for the payment also.                  government sector’s investment is lower than the
11 To decrease the tax burden: For deficit financing         private sector’s investment. The management
   either the government has to raise tax to increase        efficiency has been found more in private sector
   revenue collection or it has to print the money;          than in the government sector. So, the yield on
   both are not easy jobs. By domestic borrowing             investment will be low in the government’s
   the government can lower the tax burden of the            investment.
   people.
                                                         Classification of Debt Instruments
12 To increase the people’s participation in the
                                                            Generally the debt instruments are classified under
   national development: The borrowed money will
                                                         the following basis:
   be invested in the development projects by the
   government. So, the people who have invested          Maturity Period Basis
   in the government securities would have a feeling         The debt instruments are of different maturity
   that they have also participated in the national      periods. According to the maturity period they are
   development activities. Thus, borrowing will help     classified as:
   in developing the sense of belonging and sense            (a)Long-term security: Those debt instruments
   of ownership of the national projects by the          (securities) whose maturity period is more than one
   people.                                               year are classified under long-term security. Long-
Disadvantages of Domestic Borrowing                      term securities are known as bonds.
   Despite these advantages of internal borrowing,           (b) Short-term security: Securities having less
there are disadvantages of domestic borrowing.           than one-year maturity period are classified under
Some of the disadvantages are as follows:                short-term security. These short-term securities are
                                                                               DOMESTIC DEBT MANAGEMENT        367

also known as bills. Like other government securities,      B.S. as an independent department. The
this instrument is also the government’s obligation         responsibilities given to this department under Public
and is also guaranteed by the government.                   Debt Act-2017 B.S. and Public Debt Regulation-2020
                                                            B.S. were as follows:
Based on Objective of Borrowing
                                                            a) To sale the government securities.
     The government may borrow for some specific
                                                            b) To collect the money borrowed by the
purposes like road construction, land development,
                                                                government.
electrification, etc. Hence, the name of the issued
                                                            c) To deposit the bor rowed money in the
securities can be given after the purpose of borrowing
                                                                government account.
of that particular instruments, like irrigation bond,
                                                            d) To make payment of the government securities
electrification bond, Melamchi Drinking Water bond,
                                                                (principal and interest amount).
etc.
                                                            e) To solve the problem of ownership conflict on
Ownership Transfer Basis                                        government securities (bonds and bills).
     On the basis of ownership transfer character, the      f) To perform the advisor y function of the
debt instruments are classified as:                             government on borrowing, on interest rate, on
     (a) tock: Stock security cannot be sold by holders         designing of security papers, payment period, and
simply by the endorsement process as they are                   so on.
registered in issue offices. If the bondholder likes to         After five years of the establishment of the NRB,
sell the stock instrument, he has to come to the issue      the Public Debt Act-2017 B.S. was formulated and
authority with the buyers for the signature verification.   enacted. After the enactment of this Act, domestic
This signature verification is doing by the NRB, Public     borrowing was initiated in the country.
Debt Management Department, which is the debt                   For the first time in 2018 B.S., the government
manager of the government                                   borrowed Rs. 7.0 million by issuing treasury bills of
     (b) Promissory note: This promissory type of           90 days maturity period. This treasury bill was issued
instrument can transfer ownership by a simple process       in face value and in one percent annual coupon rate
of signature endorsement between buyers and sellers.        of interest. Thereafter, the internal borrowing by the
This type of security is registered in NRB’s record         government has become a regular process in Nepal.
during their primary issuing time only. At the time             Though HMG of Nepal has started borrowing
of selling, the owners need not to come to the NRB          since 1962, the sale of treasury bill by bidding auction
(issuing authority) for their signature verification.       was started only in 1984. The secondary market facility
Bearers Bond                                                for treasury bill like re-purchase (repo), outright sale
    With respect to this type of bonds, the bearer          and outright purchase facilities from secondary
himself is supposed to get the payment. So, the             window was started in 1994. In 1996 tap sale
signature verification of the bond’s bearer is not          window for treasury bill was opened. For the first
important in such securities.                               time in 1991, the NRB issued a central bank bond in
                                                            the name of Nepal Rastra Bank Bond 2053 B.S.
History of Domestic Borrowings in Nepal                     (Rastra Bank Rin Patra, 2053 B.S.) which was issued
    Nepal Rastra Bank was established in 1956 as a          in 1991 and matured in 1996. The NRB bond was
central bank of Nepal under Nepal Rastra Bank Act-          issued for the second time in 1996, which was the
1955. One of the objectives stated in Nepal Rastra          last bond issued in the name of central bank. At
Bank Act 1955 is to mobilize the available local            present, there are five types of domestic borrowing
resources to the national development activities. To        instruments (bills and bonds). The outstanding of
fulfill this objective, the Public Debt Act-2017 B.S.       total debt was Rs. 82411.5 million as of mid-January,
was introduced. For the management of the                   2005. The name and issued years of the bonds are
government’s internal debt, a separate division of          presented in Table 1.
Public Debt was established in Research Department,             Apart from the above five types of borrowing
NRB. Considering the importance and volume of               instruments, some instruments like Land
the work of public debt, the NRB upgraded Public            Development Bond, Land Compensation Bond, and
Debt Division to a Public Debt Department in 2023           Forest Development Bond were also issued by the
368     NEPAL RASTRA BANK IN FIFTY YEARS

government of Nepal. These instruments were one             Domestic Debt and Their Composition
time issued, so they are already matured and paid.              The outstanding amount of borrowing in the
Existing Domestic Debt Instruments and                      respective instruments and their composition has been
                                                            presented in Table 1.
Their Features
                                                                As at mid-January 2005, the government’s
     The existing five types of debt instruments are
                                                            domestic debt amounted to Rs. 82,411.50 million.
Development Bond, National Saving Bond, Citizen
                                                            The composition of debt shows that the government
Saving Bond, Special Bond and Treasury Bill. The
                                                            has borrowed the highest amount by issuing treasury
maturity period of these instruments ranges from
                                                            bills, which consists of more than 61 percent of the
28 days to 20 years. They are either promissory or
                                                            total borrowing.
stock in nature .All the bonds are issued at coupon
rate of interest and in face value. The treasury bill is    Target Group of the Debt Instruments
the government’s short-term borrowing instrument.                 The target groups of these above five types of
They are issued at a discounted auction price and the       existing debt instruments are different. Some
bill holder gets the payment in face value at maturity.     instruments are targeted to individuals, some are to
The difference between the purchase price and               commercial banks and financial institutions and some
received amount at maturity is the yield of the treasury    to both. Instruments such as National Saving Bond
bill. They all are of promissory in nature.                 and Citizen Saving Certificate are issued especially
     Among these five types of instruments, the             for the individuals. They cannot be purchased by the
treasury bill is the oldest instrument and the Citizen      institutions. They are generally promissory notes in
Saving Certificate is the latest one introduced in          nature but they can be issued in stock nature if so
Nepal. The National Saving Certificate, Citizen             demanded by the individual. Though the
Saving Certificate are issued either in stock or            Development Bond and treasury bills are very familiar
promissory types as individuals demand, whereas             to the commercial banks and other financial
Special Bonds and Development Bonds are issued              institutions, these instruments can be bought by
as stock only. Bonds, which are issued for institutions,    individuals, too. The treasury bill is issued as
can be sold to the limited institutions. For example,       promissory note and Development Bonds are stock
the bonds which are issued for insurance companies          in nature. The Special Bonds are issued for special
can be sold only to the insurance companies. Treasury       purposes as requested by HMG. All the special bonds
bills can be bought both by individuals as well as          are stock in character and they can not be bought by
institutional lenders. Issue, purchase, repurchase and      individuals.
sale of the treasury bill are completely based on
                                                            Ownership Pattern of Domestic Debt
auction and discount price, whereas all other bonds
                                                                 The highest amount of domestic debt is held
are sold on the basis of face value and coupon interest
                                                            by the commercial banks. They hold almost 63
rate.
                                                            percent out of total domestic borrowing of the


 Table 1
 Total Outstanding Amount and their Composition (Mid January 2005)
 (Rs in million)
 S.N.    Instruments                  Issued Year (B.S.)     Total Outstanding        Percentage Composition
 1       Development Bond                            2020              17549.21                          21.29
 2       National Saving Bond                        2040               9029.84                          10.96
 3       Treasury Bill                               2018              50391.65                          61.15
 4       Special Bond                                2028               4261.92                           5.17
 5       Citizen Saving Certificate                  2058               1178.88                           1.43
         Total                                                         82411.50                         100.00
 Source: Nepal Rastra Bank, Public Debt Management Department.
                                                                                                DOMESTIC DEBT MANAGEMENT           369

government. They are holding the highest amount                            the government is the highest in the current fiscal
of treasury bills (86.8 percent) than any other debt                       year and goes on decreasing in subsequent years. Table
instruments. Table 2 shows the ownership structure                         3 shows that out of total domestic debt outstanding,
of the domestic borrowing.                                                 51.71 percent is maturing within the period of one
                                                                           year (FY 2004/05) and 22.00 percent debt will
Portfolio Mix and Maturity Structure                                       mature on the next year (FY 2005/06); moreover,
    The debt manager should ensure the government’s                        9.34 percent out of total borrowing will mature on
financing needs and its payment obligation. For this,                      FY 2006/07 in comparison to only 0.05 percent in
he has to consider the debt portfolio mix in term of                       FY 2009/10. From the maturity mixing and risk
maturity profile, interest rate and portfolio creation.                    minimizing aspects, this maturity structure seems to
The portfolio mix and maturity structure of the                            be good because the risk of shifting of government
domestic debt are shown in Table 3.                                        liabilities will be less in such a maturity structure. So,
 Management Department.                                                    by fixing the shorter maturity period on the majority
    The above maturity structure shows that the                            amount of borrowing, the risk of tendency of
maturity out of the total domestic borrowing of                            shifting liability of borrowing has been minimized.

 Table: 2
 Ownership Structure of the Domestic Debt (Mid-January ,2005)
 (Rs. in million )
                          Development Natonal Saving                 Treasury         Special   Citizen Saving
 Ownership                       Bond          Bond                      Bills         Bond         Certificate                Total
 Commercial Bank                  6587.41                110.00          43755.00      944.60                        51907.01(62.98)
 Development Bank &
 Other Financial Institution      1194.95                220.24            510.00                                      1415.19(1.72)
 Other Institution                7123.27               2651.26           1855.50     2453.30              3.71      14087.04(17.09)
 Individual                        209.80               5904.86                                         1127.58        7242.24(8.79)
 Nepal Rastra Bank                2433.77                143.48           4271.15      864.03             47.58        7760.01(9.42)
 Total                           17549.20               9029.84          50391.65     4261.93           1178.87 82411.49(100.00)
 The figures in parenthesis ( )show the percentage of holding out of total borrowing.
 Source: Nepal Rastra Bank, Public Debt Management Department.


 Table 3
 Maturity Structure of Domestic Borrowing
 (Mid -January 2005)
 Maturity         Development             National          Special           Treasury      Citizen Saving
 Fiscal Year             Bond         Saving Bond            Bond                 Bills         Certificate                   Total
 2004/05                   550.00            2670.00        1651.03           37747.50                             42618.53 (51.71)
 2005/06                  2790.00             2700.0                          12644.15                             18134.15 (22.01)
 2006/07                  4282.09            2359.84         430.44                                 628.06          7700.43 (9.34)
 2007/08                  3511.69             400.00        1779.81                                 303.04          5994.54 (7.27)
 2008/09                     6.93             900.00         204.99                                 247.78          1359.70 (1.65)
 2009/010                                                     38.05                                                   38.05 (0.05)
 2012/013                 6408.50                            157.60                                                 6566.10 (7.97)
 Total                  17549.21             9029.84        4261.92           50391.65             1178.88        82411.51 (100.00 )
 Percentage                 21.29               10.96             5.17              61.15              1.43
  The figures in parenthesis ( ) show the percentage of holding out of total.
  Source: Nepal Rastra Bank, Public Debt Management Department.
370    NEPAL RASTRA BANK IN FIFTY YEARS

    Regarding the portfolio mix, it shows that the           for primary issue, secondary market arrangement,
highest amount out of total debt is by treasury bill         payment and settlement arrangements for trading of
which consists about 61 percent. Other long term             government securities and pubic discloser.
bonds are less than treasury bill; altogether, they form         For public disclosure the Public Debt
only about 49 percent out of total .The treasury bill,       Management Department of the NRB publishes the
Special Bond and Development Bonds are                       monthly reports on domestic borrowing position
institution-targeted instruments (though treasury bills      and it prepares the weekly trading position of treasury
could be bought by an individual). Almost 87 percent         bill in primary and secondary market. Also, the
out of the total government debt is the investment           Banking Office of the NRB provides the
made by the institutions (Table 2).                          information on the government’s treasury position.
    Table 4 shows that the contribution of domestic              Coordination: The government announces the
borrowing to total expenditure and domestic                  amount of domestic debt to be borrowed through
borrowing to GDP is displaying a decreasing trend            its annual budget programs .On the basis of the
since FY 2002/03 while the ratio of domestic                 government budget, the issue calendar prepared by
borrowing to revenue is increasing. All these indicators     the NRB will be approved by the Ministry of Finance
show that government is trying to increase its capacity      (forwarded by the Open Market Operation
in revenue collection and trying to reduce gradually         Committee). The quarterly basis annual issue calendar
its dependency on borrowings.                                is prepared on the basis of past trends of
Aspects of Debt management                                   government revenue and government expenditure
    The following different aspects are taken into           in each quarter.
consideration with respect to debt management:                      To establish the cordial coordination between
    Transparency and Accountability: Different               fiscal and monetary policy and domestic debt
organizations especially Ministry of Finance (MOF),          manager, there is a provision of Open Market
NRB and Financial Controller General’s Office                Operation Committee (OMOC) under Public Debt
(FCGO) are closely related with each other for               Management Act 2059 B.S. The Deputy Governor
domestic debt management activities. The                     of the NRB chairs this Committee, and Executive
accountability of each organization has been clearly         Directors of NRB from Research Department, Bank
stated in the Domestic Debt Act-2059 and Domestic            and Non-bank Institution Regulation Department,
Debt Regulation-2059 B.S. Responsibilities are clearly       NRB Banking Office, Public Debt Management
allocated among the MOF, FCGO and debt manager               Department, Directors of Public Debt Management

 Table 4
 Some Important Indicators (Mid-January 2005)
 (Rs in million)
 Descrption                                        2000/01     2001/02       2002/03       2003/04    2004/05*
 Total Expenditure                             79835             80072         84006         92107       111690
 Development expenditure                       37066             31482         29033         32810     31577 @
 GDP                                          411217            422676        456201        495336     537449 #
 Total Revenue                                 48894             50445         56230         62330        72700
 Domestic borrowing                             7000              8000          8880          7312         6090
 Total Deficit                                  3094             29626         27776         29777        38990
 Domestic borrowing /GDP                         0.02              0.02          0.01          0.01        0.01
 Domestic borrowing /Devevelopment expenditure 0.19                0.25          0.31          0.22        0.29
 Domestic borrowing /Revenue                     0.14              0.16          0.16          0.12        0.12
 Domestic borrowing /Total expenditure           0.09              0.10          0.11          0.08        0.08
 * Estimated
 @ Capital expenditure
 Source: i) Budget Speech 2004/05 and 2003/04
         ii) # Central Bureau of Statistics
                                                                             DOMESTIC DEBT MANAGEMENT         371

Department and Joint-Secretary from Ministry of           debt is higher on treasury bill because out of the
Finance and Financial Controller Office are also          total outstanding 61.15 percent debt is borrowed by
members of the Committee. The responsibilities of         issuing treasury bill (Table 3).
the OMOC are as follows:                                      To make the risk management effective, the debt
  - To decide on the amount, issue date, and maturity     manager should be provided the information on past
    periods of the bills and the          bonds to be     budgetary activity, present situation and projected
    issued.                                               budgetary position like revenue collection,
- Plans for the new issue (on the basis of approved       expenditure, treasury balance, and so on. The debt
    issue calendar).                                      manager should provide the published information
- To announce the treasury bill’s auction bidding         on the stock, composition of the debt and financial
    and award the biddings.                               assets including currency, maturity and interest rate
- To recommend issuing new bonds to HMG.                  to the government.
- To recommend on the amendment of the                        Auditing of the debt management activity:
    domestic debt policy to the government.               Audit should be done by the external auditors
- To decide on all other related issues on the            annually for the domestic debt management and all
    treasury bill and domestic debt management.           the sug gestions from the auditors should be
- To maintain the optimum level of liquidity in the       incorporated.
    system through primary and secondary market               Legal framework: Functional responsibilities of
    operation. For this, the OMOC will decide             the related organizations should be clearly stated and
    whether the liquidity has to be injected in the       has to be guided by an act and regulations. In Nepal
    system or has to be drained out from the system       the different aspects of the domestic debt
    temporally or permanently.                            management are guided by Nepal Rastra Bank Act-
    The OMOC uses two general approaches to               2002., Public Debt Act–2059 B.S. Public Debt
maintain the optimum level of reserve in the system.      Regulation-2059 B.S. and Public Debt Management
When a significant increase of liquidity is expected in   Working Guidelines-2060 B.S.
the system for relatively a long period, the OMOC             According to the Nepal Rastra Bank Act 2002,
may decide to go for outright sale, reverse repos or      the government can borrow through overdraft facility
fresh issue through primary market which will affect      from the central bank up to the amount of five
the size of central bank’s portfolio and it will reduce   percent of the total revenue of the last fiscal year.
the reserve in the system. Likewise, when the liquidity   The total holding limit of the government securities
shortages are expected in the economy for the shorter     by the central bank has also been limited to ten percent
duration, such liquidity can be adjusted in the market    of the last fiscal year revenue of the government.
through purchase, repos and standing liquidity facility   By this legal limitation, the possibility of excess
because portfolio growth is achieved through              borrowing and risk of debt trap has been minimized.
repurchase agreement and outright purchase and                Internal operation control: There may be the
portfolio contraction is achieved through sales and       chances of risk of losses from inadequate internal
reverse repurchase agreement and by allowing              operation control. So, there should be internal
holding to mature without replacement.                    operation control accordingly and sound business
    Risk management: Long -term borrowing may             practices including well-articulated responsibility for
be more risky than short-term debt in one situation       the staffs, clear monitoring, periodically reporting and
whereas in another situation, the risk may be vice-       control mechanism should be established. For this,
versa. Borrowing on fixed interest and coupon rate        the division of work, span of control, authority, and
of interest may be more risky; likewise, there should     the working procedures are mentioned on the Public
not be over concentration of borrowing on the same        Debt Management working guideline of the
types of securities and on the same period of maturity    department.
to minimize the crowding risk. The maturity structure     Domestic Debt Management Practices in
for the next seven years with respect to the borrowing    Nepal
instrument shows that most of the debts are                  The Public Debt Department has given a new
borrowed for shorter period. But concentration of         name as Public Debt Management Department since
372    NEPAL RASTRA BANK IN FIFTY YEARS

2004. Under the Public Debt Act-2059 B.S. and                  (a) Announcement of sale: Sales announcement
Public Debt Regulation 2059 B.S. this Department          is published in the daily national newspaper with all
on behalf of the NRB is undertaking the domestic          the features of the instruments and selling and buying
debt management functions. The Public Debt                details like opening and closing date of selling,
Management Department is managing the domestic            interest rate, offered amount, applying procedures,
debt by adopting the following operational                selling counters, eligibility of applicants, etc. All these
procedures:                                               features have to be approved by the Ministry of
                                                          Finance. This announcement is important for those
Policy Recommendation
                                                          who are willing to invest in government security. Such
    If some rectification and amendment is needed
                                                          announcement for primary issue is made for all bonds
in the domestic debt act, borrowing policy and
                                                          except for Special Bond.
regulation, it will recommend to the government for
                                                               (b) Sale of security: Selling starts in the
the amendment and rectification.
                                                          announced date. The demand application form can
Advising to the Government                                be collected from the selling counters. The borrowers
    It advises on the level of internal borrowing         have to follow the prescribed procedures to apply
requirement for the government during the coming          for obtaining such securities. Applicants have to fill
fiscal year. Basically this forecasting is based on the   up the prescribed form. He/she has to mention his/
government expenditure, income, GDP level and             her name, address, amount and types of certificate
deficit financing.                                        he likes to have (stock or promissory notes),
                                                          denomination of the certificates, sign and stamps
Preparation of Issue Calendar
                                                          (stamps in case of institutions). After filling up the
    This function of management starts when the
                                                          application, one can submit such demand form in
government announces the budget for the fiscal year.
                                                          the selling counter with their cash voucher and
The total targeted domestic borrowing amount is
                                                          citizenship certificate attached. In the case of bonds,
divided into four different quarters for primary issue.
                                                          the applicant has to deposit the total demanded
The amount to be issued is projected on the basis of
                                                          amount. The demand application form is free of
the trends of the government income and
                                                          cost for the bonds and can be obtained from all the
expenditure, revenue collection level, and cash
                                                          selling counters .The borrowers can buy the bonds
position projection for the periods. The government
                                                          either in sole ownership or in joint- ownership. There
income and expenditure may not be distributed
                                                          is also the provision of buying the bonds in the name
evenly throughout the fiscal year. In one quarter the
                                                          of infant by their guardians.
income may exceed the expenditure while in the other
                                                               (c) Closing of sale: Generally, the sale of
quarter, the expenditure may exceed the income.
                                                          securities may stop at the announced date and time;
Thus, the issue schedule is prepared according to the
                                                          but sometimes, the selling may be oversubscribed
level of government’s deficit projection. The amount
                                                          before the closing date that was announced. In such
proposed to issue in each quarter may not be equally
                                                          a situation the selling may close at the oversubscribed
divided. The issue calendar is finalized by OMOC
                                                          date.
and approved by the Ministry of finance. This
                                                               (d) Collection of demand applications and
approved calendar will be available in the bank’s
                                                          demanded amount: When the selling of securities
website for the information to interested people.
                                                          is closed, all the applications with their demanded
    The preparation of issue calendar has started since
                                                          amounts are collected from each of the selling
the FY 2004/2005. This issue calendar will be helpful
                                                          counters (NRB, commercial banks and market
for investment planning and portfolio management
                                                          makers outside the Kathmandu valley) and the
of the banks and other financial institutions. It is
                                                          demand list is also prepared.
equally useful for the government for their treasury
                                                               (e) Allocation of demand: Demand allocation
management.
                                                          is done as per the OMOC’s decision. If the
Primary Issue Management of Bonds                         demanded amount is equal to less than the offered
    On the basis of the approved issue calendar, the      amount, in general, the applicants receive the full
following procedures are followed in primary issue        amount in accordance to their demand; otherwise,
of bonds:                                                 if the demand is more than the offered amount, there
                                                                              DOMESTIC DEBT MANAGEMENT         373

may be the chances of getting less than the demanded        Issue of Treasury bill by Bidding Auction
amount . In case of oversubscription, the OMOC                  The treasury bills are issued on the basis of
allocates the amount, applying different techniques         multiple price-bidding auctions and on discounted
such as pro-rata basis, stratified basis, and multi-        rate. Any interested institutions and individuals can
stratified allocation methods. But it has never used        participate in bidding auction. The bidders are
the lottery method for allocation. The OMOC tries           classified into two groups: non-competitive and
to allocate the offered amount to the largest possible      competitive. The commercial banks and
number of people. If the applicants do not get any          development banks doing the commercial functions
amount of bond or if they get less than the                 are classified under competitive bidders while the
demanded amount, the excess of the deposited                other bidders are classified under non-competitive
amount will be refunded within 15 days of the               bidders. Out of the total offered amount in each
decision taken by the OMOC for the allocation.              issue, 15 percent is allocated for non-competitive
    (f) Preparation of the certificates: On the basis       bidders. The bidding and bid awarding process for
of allocation sheet as approved by OMOC, the                treasury bills are as follows:
certificate has to be prepared in the applicant’s name.         (a)Call for bidding: Information on auctioning
These certificates are signed and stamped by the            of treasury bill is published on national daily
concerned authorities. Some of the very essential           newspaper and also kept in the bank’s website.
features like name of bond, types of bond, owner’s          Generally treasury bills are issued on Tuesday (for
name, face value of the certificate, registration           91-day and 364-day treasury bills) and Thursday (for
number, serial number, issued date and maturity date,       28-day and 182-day treasury bills). In the notice, all
must be mentioned clearly on the certificate. There         the information like series number, issued date,
will be a separate certificate for principal and for        maturity date, offered amount, whether fresh or
interest amount. The amount of interest, date of            renewal, last biding date and time are published. Apart
payment and number of payment has to be                     from this infor mation, other supplementary
mentioned on the interest certificate.                      information like number of bidders, bid amount,
    (g) Distribution of the certificates: The               offered amount, left over amount, accepted weighted
certificate is distributed from the same institutions       average discount price, and maximum and minimum
from where the applicants have submitted their              accepted bid price on the last auction are also
application forms. During delivery of the certificate,      published.
he/she has to keep in mind that the certificate should          The bidder could obtain the bid form by paying
be delivered very safely. For safety purposes, the          Rs. 10.00 per form with the envelopes. This form
NRB delivers the certificate by hand inside and outside     can be purchased from the Public Debt Management
the Kathmandu valley. During delivery of the                Department in Kathmandu and any branch of Nepal
certificate to the applicants, the broken period interest   Rastra Bank stationed outside Kathmandu. The bid
has to be given. Especially for the individuals (Citizen    forms are of different color for 91-day treasury bills,
Saving Certificate, National Saving Certificate),           364-day treasury bills and for non-competitive
certificates are issued with open signature of the          bidders. Before submission of the bid forms, the
owners. So, there are chances of encashment of these        bidders have to mention every detail in their form
certificates if they are stolen or lost. Thus, the bond-    such as series number of the demanded treasury bill,
holders have to be very careful and keep these              demanded amount, and bid price (discounted price).
certificates safely.                                        The bid price has to be mentioned on the basis of
Secondary Market Management of Bonds                        Rs. 100.00 for demanded amount. For the
                                                            noncompetitive bidders the discount price need not
    The secondary market functions for the bonds
                                                            to be mentioned. For each bid price, they have to
are being provided through the market makers. The
                                                            submit the bid form separately. Lastly, they have to
buying and selling of bonds are trading at par (face
                                                            sign, in case of institutions by two authorities and
value) .The buyer has to pay the interest at the coupon
                                                            stamps. The bidder has to mention the bid price in
rate of the bonds unto the previous day’s transaction
                                                            four decimals. The bid price is also known as the
to the seller. There is no discount system and premium
                                                            discounted price which means the bidders are ready
facility.
374      NEPAL RASTRA BANK IN FIFTY YEARS

to invest that much of the price at present and the        Where,
face value amount will be paid at maturity.                    D.R = Discount rate ( as quoted by bidders)
    The voucher of the deposited earnest money                 B.P     = Bid price
could be attached with bid forms (2.5 percent of               Terms = Maturity period of the given treasury
the bid amount). The earnest money can be deposited                       bill.
in the NRB’s Banking Office Kathmandu and in any               (d) Bid award: This being the multiple price
branch of NRB Kathmandu. The bid form should               auction, the successful bidders have to pay according
be enclosed in the envelope and should be dropped          to their quoted price for their bid amounts. So while
in the tender box in Public Debt Management                awarding, the highest bid price should get the higher
Department of the NRB. The bidders from out of             preferences. This is important in order to minimize
the Kathmandu valley can submit their bid form in          the borrowing cost of this particular issue. For this,
the NRB’s branches.                                        the above computer generated data are arranged in
    (b) Verification and recording: After the bid          diminishing order of the bid price or in increasing
forms are opened, they should be verified. During          order of the discount rate as follows:
verification, it has to be checked whether or not the
bidders have mentioned the important information                Name of                  Bid        Bid      Discount
                                                            S.N Bidders                 Amount     Price       Rate   Accepted
such as bidding, discounted price, bid amount, name
and signature of the bidders, stamps so on. If such         1     N . Bank Ltd           20.00    98.8875      2.2500        20.00
                                                            2     N . Bank Ltd           20.00    98.8631      2.2999        20.00
important information is missing, this will be minutely     3     S . Bank               3.00     98.5128      3.0193        00.00
noted down and finally such bids will be discarded.         4     K . Bank Ltd           3 .00    98.4398      3.1699        00.00
The bids are recorded in the recording register as          5     K . Bank Ltd           3 .00    98.3763      3.3010        00.00

mentioned below (the case presented below is                      Total                  49.00                               40.00
hypothetical):
                                  Amount : (Rs in crore)   Award summary,
                                                                                            Highest price                      98.8875
      Name of           Number of      Bid                 N. Bank LtdRs. 40.00 crore       Lowest price                       98.8631
 S.N. Bidders           Bid Forms     Amount    Remarks                                     Highest Rate                        2.2500
                                                                                            Lowest Rate                         2.2999
 1       K. Bank Ltd        2          6.00                                                 Average Weighted Price             98.8753
 2       S . Bank           1          3.00                                                 Weighted Average Discount Rate      2.2750
 3       N. Bank Ltd        2          40.00               Calculation
         Total              5          49.00               1. Average Weighted Price (A.W.P)
                                                               A.W.P = Σ (B.P * Accepted amount)
                                                                             Σ Accepted amounts
Assumption : The amount to be issued is Rs. 40.00
                                                           2. Average Weighted Rate (A.W.R)
crore.
                                                               A.W.R = Σ (D.R * Accepted amount)
   In this case the amount is oversubscribed by Rs.
                                                                            Σ Accepted amounts
9.00 crore.
                                                               In the above situation, the N.Bank’s bids have
c) Computer entries: The recorded bids are
                                                           been accepted. By awarding the bids to the N. Bank
entered in the computer-spread sheet. The details are
                                                           which has quoted highest bid price, the cost of
entered in the following format:
                                                           borrowing for this issue will be minimum than
         Name of         Bid          Bid      Discount    awarding to other bidders because the lowest rate
  S.N.   Bidders        Amount       Price       Rate
                                                           or the highest price has given the preference; as a
  1      K. Bank Ltd      3 .00     98.4398     3.1699
  2      K .Bank Ltd      3 .00     98.3763     3.3010
                                                           result of this decision, the interest risk and cost of
  3      S . Bank          3.00     98.5128     3.0193     borrowing will be reduced.
  4      N .Bank Ltd      20.00     98.8875     2.2500         Although the rates are determined by the market,
  5      N . Bank Ltd     20.00     98.8631     2.2999
                                                           the rate should be representative of the current market
         Total            49.00
                                                           rate and there should not be any indication of
Calculation of discount rate:                              speculation and cartelling. So, the decision makers
  D .R = (100-B.P)*364*100                                 should keep their eyes on the current market situation.
                 B.P * Terms                               Additionally, they should be very conscious about
                                                                                 DOMESTIC DEBT MANAGEMENT          375

the possibilities of cartelling and unnatural response        holders at the date mentioned on the certificates, even
from the bidders. If they feel that the responses are         though the government delays the payment to the
not in normal trends and not representing the market,         NRB. The payment of interest of the securities can
they have the right to fix the cut off price and the          be obtained through any of the commercial banks,
authority not to award the bidders. They should               development banks and market makers. They get
always keep in mind that a good pricing in auction is         the commission out of this interest payment. The
possible by good participation only.                          reimbursement of payment and commission will be
    (d) Account settlement: On the issued date,               provided through the NRB.
the biding account will be settled. Those who are
                                                              Record Keeping
not able to receive the treasury bill will get refund of
                                                                  This is one of the important parts of the debt
their earnest money and the successful bidders have
                                                              management. For this, the NRB maintains the data
to deposit the difference amount (difference of
                                                              and furnishes this information to the concerned
discounted accepted amount and deposited earnest
                                                              organizations. Details such as total borrowing, total
money). The N. Bank has to pay at the discount
                                                              liability of the government, increment level of
price of 98.8875 for Rs. 20.00 crore and 98.8631
                                                              borrowing each year, maturity structure, types of
for the next Rs. 20.00 crore. This difference amount
                                                              instruments used, ownership pattern, issue and
should be deposited no later than the issue date. If
                                                              maturity date of each issuance are clearly recorded
the successful bidder fails to deposit the difference
                                                              and disclosed.
amount within the given time, the deposited earnest
money will be seized. The certificate preparation             Promotional Activities of Government
and distribution process is the same as in the issue of       Securities
bonds.                                                            In order to promote and strengthen the securities
Secondary Market Management of Treasury                       market, the NRB is undertaking the following efforts:
                                                                  (a)Public awareness program: The NRB, as a
Bill
                                                              domestic debt manager, regularly conducts seminar,
    The secondary market facility is provided to the
                                                              interaction program and talk program for the senior
bill holders by the NRB only. There is no market
                                                              officials of the banks and financial institutions. It also
maker for the treasury bill. Presently, five windows
                                                              conducts the training and interaction programs for
are opened for secondary market; they are out right
                                                              other front, middle and back officers of the related
sale, out right purchase, repo, reverse repo and
                                                              institutions, for individuals and for the market makers.
standing liquidity facility (SLF). All these facilities are
                                                              These programs are conducted in different regions
auction based except the SLF. The SLF is collateral
                                                              of the country. From such program, people may
based and the interest rate is based on 91-day treasury
                                                              enhance their knowledge relating to buying and selling
bills auction rate. The SLF can be used at any time
                                                              of the government securities and their management.
by the government securities holders whereas the
                                                                  (b) Development of market makers: The
other windows can be used only when the NRB
                                                              government securities are widely accepted. The
announces for auction. The OMOC bears the full
                                                              securities holders are scattered throughout the
authority to take all the decisions on treasury bill
                                                              country. The interested individuals should be able to
auction.
                                                              buy and sell the government securities at any time
Facility of Duplicate Certificate                             and from their nearest agency. So, the NRB is
    In case the owner lost and tears his certificate, the     providing the permission (license) to the interested
NRB issues the duplicate certificate. To get the              banks, finance companies and cooperatives to do
duplicate certificate, the owner has to submit the            the function of buying and selling of such securities.
application in the nearest NRB’s office with certain          They are known as market makers. Thee licenses of
evidences.                                                    the market makers can be renewed each year. There
Payment                                                       are 46 such market makers for FY 2004/05. They
    It is HMG’s obligation to pay the interest and the        are operating throughout the country. To be a market
principal amount to the owners timely. On behalf              maker, they must meet the minimum paid up capital
of HMG, the NRB makes payment to the securities               standards.
376    NEPAL RASTRA BANK IN FIFTY YEARS

    The market makers purchase and sell the                 limited function on government securities. These
government bonds in the secondary market under              market makers are mostly concentrated in the
the prescribed norms and directives given by the            Kathmandu valley. As a result, the market facilities
NRB. They also help in selling the government bonds         are not yet well spread throughout the country.
in the primary issue. By this arrangement, people               (e) The policy is underway for trading and listing
need not to come to the central bank for buying and         of the government securities through security
selling of government securities. They charge the           exchange market. By trading the government
commission for their secondary market transactions          securities in the security exchange market, the investors
activities. For primary issue also, they are paid the       will be certainly benefited and trading will be on the
commission by the government on the basis of                basis of market demand and supply. Trading will
amount of their sale.                                       reflect the real market situation. The securities will
                                                            be traded on either premiums, discount or par value.
Challenges and Suggestions for Debt
                                                            But maintaining the investors’ confidence is a must
Management                                                  for the well-functioning of the security markets.
     The size of the fiscal deficit that affects the size   Before going to real trading on the security markets,
of internal borrowing is increasing every year. Hence,      there should be wide trading network, good
for the development of the government securities            infrastructure, efficient manpower, transparent floor
market, an efficient management system should be            trading system and settlement. Otherwise, the impact
established. The following areas has to be developed        will not be as expected.
and strengthened in the future:                                 (f) Central depository system: To be an efficient
     (a) Scripless system : The size of domestic debt       security market the settlement of the transaction
in terms of volume and quantities are increasing. The       should be completed within a very short period of
paper certificate system and the delivering of the          time. Only through the central depository system can
documents physically are the time consuming process         we make the existing settlement duration shorter.
and certain risk are also involved in delivering the            (g) A higher-level debt policy coordination
documents physically. For the prompt and efficient          committee: As this high level apex committee will
service, developing the scripless system is one of the      be responsible for the national debt strategy and
important areas.                                            debt policy, there should be a provision of such central
     (b) Networking : Net working will make the             committee for the policy formulation and effective
communication and sharing of the information easy.          implementation.
For this, at least we need to go for the Local Area             (h)      Monitoring mechanism: It is widely
Network (LAN) or City Area Network (CAN)                    accepted that the borrowing amount should not be
immediately.                                                used in non-productive sectors like regular
     (c) Improvement in the debt recording system:          expenditure of the government, buying for arms and
There are no consolidated debt records available in         ammunition. Otherwise, the situation would be like
Nepal. Different organizations are involved in the          “debt for debt payment” which will lead to a debt
debt management. Domestic debt is managed by                trap. Thus, there should be a monitoring mechanism
the NRB, and external debt is managed by the                for the borrowed money.
Ministry of Finance and Financial Comptroller Office.
The payment part is solely taken care of by the             Conclusion and Suggestion
Financial Comptroller Office. However, these                    To manage the government borrowing efficiently,
organizations are found to be working without any           development of an efficient government security
close cooperation. So, to have an efficient and             market is a must. The borrowing should be invested
consolidated data recording, a need-based and a             in the productive sector. The financial return to
user friendly debt management recording software            government out of these investments should be
is a prerequisite.                                          greater than the cost. The assets created out of such
     (d) Development of security market: The                borrowing (yield) should be at the higher level. The
primary and secondary market functions of                   borrowing cost and return should be widened every
government securities are done by the NRB in Nepal,         time. The objective of borrowing should not be for
though there are some market makers undertaking a           making easy money for the government. If the return
                                                                             DOMESTIC DEBT MANAGEMENT        377

is less than the borrowing cost, this will result in the   disclosure system, good floor trading arrangement,
gradual deterioration in the paying capacity of HMG        prompt settlement systems, etc. could enhance the
and finally the public will have less confidence on        demand of such government securities.
HMG.
                                                           References
     The borrowing instruments can be used for
                                                           Akhtar, M. A. 1997. “Understanding Open Market
maintaining monetary balance as well as for HMG’s
                                                              Operation.” Public Information Department,
financing. So, there should be a cordial coordination
                                                              Federal Reserve Bank of New York.
between fiscal and monetary policy maker and debt
                                                           Basyal, Tul Raj. 2003. “Why Fiscal Prudence?” Nepal
manager. They should share their common interests
                                                              Rastra Bank Samachar (Annual Publication).
to attain both the goals.
                                                           Friedman, Steven. 2005. “Market Monitoring.” Public
     The borrowing should not be for the payment
                                                              Information Department, Federal Reserve Bank
of interest and principal amount. It should be invested
                                                              of New York.
in the productive sector so that return from such
                                                           Ministry of Finance. 2003. Budget Speech 2003/04.
investment will be sufficient for repayment. Hence,
                                                              Kathmandu: Ministry of Finance.
an efficient monitoring mechanism should be
                                                           Ministry of Finance. 2004. Budget Speech 2004/05.
developed. While the quantitative increase in the
                                                              Kathmandu: Ministry of Finance.
domestic borrowing is not that important, the
                                                           Ministry of Finance. 2004. Economic Survey 2003/04.
meaningful use of such borrowing is more crucial.
                                                              Kathmandu: Ministry of Finance.
     For the implementation of the issue calendar a
                                                           Musgrave, Richard A. and Peggy B. Musgrave. 1989.
very cordial coordination is needed between the fiscal
                                                              Theory of Public Finance. McGraw Hill International
manager and domestic debt manager of the country.
                                                              Edition.
Through the primary issue of the government
                                                           NRB. 1996. Forty Years of Nepal Rastra Bank.
securities liquidity will be drained and there will be a
                                                              Kathmandu: NRB.
decline in the reserve position in the financial system.
                                                           NRB. 2003. Monetar y Policy for FY 2003/04.
So, the fiscal manager should be aware of this effect
                                                              Kathmandu: NRB.
on the monetary sector. Likewise, the monetary
                                                           NRB. 2004. Monetar y Policy for FY 2004/05.
authority should also bear in mind that it is also used
                                                              Kathmandu: NRB.
for fiscal management of the government.
                                                           Woelfel, Charles J. 2002. Encyclopedia of Banking and
     The supply of government securities can be more
                                                              Finance. New Delhi: S. Chand & Company
efficient by developing an efficient primary market,
                                                              Limited.
projection of government treasury position, and safe
                                                           Zabka, Natasha. 2004. “Securities Lending and
and efficient channel for distribution of securities.
                                                              Federal Reserve Program.” A Paper Presented
For this, we can create auction syndicates, primary
                                                              at the U.S Monetary Policy Implementation
dealers and brokers. Likewise, establishment of a
                                                              Seminar. Public Information Department, Federal
clear line of control, transparent record-keeping and
                                                              Reserve Bank of New York
378   NEPAL RASTRA BANK IN FIFTY YEARS




                               International Relations
                                             Rameswori Pant
                                         Director, Research Department
Introduction                                                          Financial Conference - popularly known
    NRB is related with the international                             as the Brettonwoods Conference. The
financial organizations, that provide                                 conference decided to establish the two
financial facilities and technical assistance,                        institutions, International Monetary Fund
like the IMF, World Bank, and Asian                                   (IMF) and the International Bank for
Development Bank. NRB has also been                                   Reconstruction and Development (IBRD)
related with the regional organizations                               known as World Bank today. When these
such as South East Asian Central Banks                                two organizations were established, an
Research and Training Center (SEACEN)                                 organization to promote world trade
and the South East Asia, New Zealand                                  liberalization was also contemplated. But
and Australia (SEANZA) central banks group, Asian         it was not until 1995 that the WTO was set up. In the
Clearing Union, and the SAARCFINANCE (forum               intervening years GATT tackled trade issues.
of the SAARC central banks).                                  The IMF came into existence in December 1945
                                                          and began financial operations in March 1947.It is
International Monetary Fund                               an independent specialized agency of the UN,
   The Depression of the 1930's weakened the              encompassing 184 member countries.
economic activities and the Second World War of               IMF 's purposes as stipulated in its Articles of
the early 1940's destroyed the infrastructure of the      Agreements are:
major industrial countries. After the outbreak of the
war, consideration of the post-war world financial        - to promote international monetary cooperation,
system began in both the United Kingdom and the           - to facilitate the Expansion of international trade;
United States. British economist John Maynard             - to promote exchange stability, and assist in the
Keynes wrote a proposal for the establishment of              establishment of a multilateral system of payments,
the International Clearing Union known as "Keynes         - to provide temporary financial assistance to
Plan" and the American economist Harry Dexter                 countries under adequate safeguards to help ease
White wrote proposals for International Stabilization         balance of payments adjustments.
Fund and a Bank for Reconstruction and                        The IMF's accounting unit is the Special Drawing
Development known as "White Plan". Two plans              Rights (SDR). It is international reserve asset
were taken up at the Bretton Woods conference in          introduced by the IMF in 1969.SDR's sometimes
July 1-22,1944 when representatives from 44               known as paper gold, although they have no physical
countries met at the United Nations Monetary and          form -have been allocated to member countries (as
                                                                                INTERNATIONAL RELATIONS     379

book keeping entries) as a percentage of their quotas.        (a) It reviews and monitors the national and
The SDR's value is set daily using a basket of four       global economic and financial developments and
major currencies; the Euro, the Japanese Yen, the         advices its members on the improvement in their
Pound Sterling and the U.S Dollar. The composition        economic policies (Surveillance)
of the basket is reviewed in every five years to ensure       (b) It lends the member countries the hard
that it is representative of the currencies used in       currencies to support their adjustment and reform
international transactions, and the weights assigned      policies which was designed to correct balance of
to the currencies reflect their relative importance in    payments problems and promote sustainable growth
the world's trading and financial system. As of May       (lending)
27, 2005 1SDR =1.48516 US $.                                  (c) It also offers a wide range of technical
                                                          assistance as well as trainings for government and
Resources of IMF
                                                          central bank officials. Training by the institute has
    The IMF's resources come mainly from the quota
                                                          helped to standardize the methods of gathering and
(capital) subscriptions that countries pay when they
                                                          presenting balance of payments, monetar y,
join the IMF. Countries pay 25 percent of their quota
                                                          government finance and financial statistics.
subscription in Special Drawing Rights (SDR's) or
major currencies. The remaining subscription payable      Surveillance
in the member's own currency. Unlike some                     A core responsibility of the IMF is to promote a
international organizations that operate under a one-     dialogue among its member countries on the national
country one-vote principle, the IMF has a weighted        and international consequences of 'surveillance'. The
voting system. , The larger a country's quota in the      IMF has a mandate under Article IV of its Articles
IMF the more votes it has but the board does not          of Agreement to exercise surveillance over the
make always decisions based on formal voting's;           exchange rate policies of its members in order to
rather most decisions are based on consensus among        ensure the effective operation of the International
its members and are supported unanimously. Quota          Monetary System. Article IV consultations usually take
determines the country's subscriptions payments, its      place once a year .IMF economists visit the member
voting power, the amount of financing that it can         countries to gather information and hold discussions
receive from the IMF and its share in SDR allocation.     with government and central bank officials, Upon
Quotas are intended broadly to reflect member's           their return the mission submit a report to the IMF's
relative size in the world economy. The larger a          Executive Board for discussion. The Board's views
country's economy in terms of output and the larger       are subsequently summarized and transmitted to the
and more variable its trade the higher its quota tends    concerned country's authorities. Before 1977,the
to be. The United States of America, the world's          IMF's assessments of member countries policies
                                                          were treated as confidential documents. In recent
largest economy contributes 17.50 percent of total
                                                          years it has become increasingly transparent.
quota whereas Palau's contribution is 0.001 percent
                                                          Surveillance today covers a wide range of economic
of total quota. Quota is generally reviewed in every
                                                          policies. The topics covered under the surveillances
five years. The most recent (eleventh) quota review       are exchange rate, monetary and fiscal policies,
came into effective in January 1999,raising IMF's         structural policies, financial sector issues and the
quota by about 45 percent to SDR 212 billion (almost      institutional issues. Now a day's assessments of risks
US$ 290 billion).                                         and vulnerabilities stemming from large and
      If necessary the IMF has two sets of lending        sometimes volatile capital flows have become focal
arrangements to borrow to cope with any threat to         issue to IMF surveillance.
the international monetary system as General                  The IMF also continuously reviews global
Arrangements to Borrow (GAB) and New                      economic trends and developments, which is known
Arrangements to Borrow (NAB).                             as global surveillance. The main reviews of this kind
                                                          are based on World Economic Outlook reports
IMF's Activities
                                                          prepared by IMF staff normally before the semi-
   IMF provides services to its member countries          annual meetings of the International Monetary and
basically in three ways that are as:                      Financial Committee. It also examines policies
380    NEPAL RASTRA BANK IN FIFTY YEARS

pursued under regional arrangements as the Euro               times a week. The IMF's five largest shareholders -
Area, the West African Economic and Monetary                  the United States, Japan, Germany, France and the
Union. IMF management and staff also participate              United Kingdom and China, Russia, and Saudi Arabia
in surveillance discussions of such group of countries        - have their seats on the Board. The other 16
as the G-7 and APEC.                                          Executive directors are elected for two - year terms
                                                              by group of countries, known as constituencies. The
Conditionalities
                                                              chief executive selects the Managing Director, who
   IMF's lending is conditional on policies. The
                                                              works as the chairperson of the board and also is
borrowing country must adopt policies that promise
                                                              the chief of the IMF staff. The managing director is
to correct its balance of payments problems. The
                                                              appointed for a five-year term and is assisted by
conditionalities associated with IMF lending helps to
                                                              Deputy Managing Directors. At present, Mr. Rodrigo
ensure that by borrowing from the IMF a country is
                                                              de Rato, a Spanish national, is the Managing Director
able to strength its economy and repay its loan. The
                                                              of IMF from June7, 2004, succeeding Mr.Horst
country and the IMF must agree on the economic
                                                              Kohler.
policy actions that are needed.
                                                              Nepal Rastra Bank and the IMF
Technical Assistance and Training
                                                                  Nepal became the member of IMF on
    Besides supervising the international monetary
                                                              September 6, 1961. Nepal's initial quota at the Fund
system and providing financial support to member
                                                              when it joined was US$ 7.5 million which increased
countries, the IMF assists its member countries by
                                                              to US$ 10.0 million in 1966,SDR 10.40 million in
running an training institute in Washington D.C. and
                                                              1971, SDR 10.90 million in 1978, SDR 20.85 million
other regional training institutes, by making technical
                                                              in 1983 and SDR 52.0 million in 1990. At present
assistance available to member countries in certain
                                                              Nepal's quota at the Fund is SDR 71.3 million,
specialized areas of its competence, and by issuing a
                                                              which is 0.03 percent of total quota of IMF. Total
wide variety of publications relating to monetary,
                                                              votes of Nepal amounted to 963, which is 0.04
government finance and balance of payments.
                                                              percent of total votes. In view of its small size,
    The institute offers courses and seminars from
                                                              Nepal disseminates opinions and decisions on
all member countries whose work is closely related
                                                              various policy issues with the South East Asian
with the work of the Fund. Most participants would
                                                              Voting Groups comprising Fiji, Indonesia, Lao
be the employees of finance ministries, central banks,
                                                              Democratic Republic, Malaysia, Myanmar,
and other financial institutions. Training by the institute
                                                              Singapore, Thailand, Tonga, and Vietnam. The
has been helping to standardize throughout the world
                                                              group's total combined quota represents SDR
the methods of gathering and presenting balance of
                                                              6548.7 million. Which is 3.1percent of the Fund's
payments, monetary and financial statistics to the
                                                              total quota and total combined votes are 65730 (3.2
benefit of the entire memberships.
                                                              percent). Nepal exercises its voting rights
Governance and Organization                                   independently through its representative at the Board
    The IMF is accountable to the governments of              of Governors. As each member country appoints
its member countries. At the apex of its organizational       a governor - usually the country's minister of finance
structure is its Board of Governors, which is the             or the governor of the central bank - and an
highest authority governing the IMF. It consists of           alternate governor. The governor of Nepal Rastra
one governor from each of the IMF's member                    Bank represents Nepal in the Fund's governing
countries - usually the country's minister of finance         board.
or the governor of the central bank. All the
                                                              Facilities used by Nepal
Governors meet once each year at the IMF-World
Bank Annual Meetings. The Board of Governors                      IMF makes its financial resources available to
decides on major policy issues but it has delegated           member countries through a variety of financial
the day-to-day decision -making to the Executive              facilities The IMF levies charges on these drawings
Board. The Executive Board consists of 24 Executive           and requires that members repurchase (repay) their
Directors, with the managing director as the                  own currency from the IMF. Nepal has used the
chairman. The executive Board usually meets three             following facilities from IMF:
                                                                                 INTERNATIONAL RELATIONS       381

First Reserve and Credit Tranches                          of merchandise imports equivalent. To overcome
    Though Nepal become member of the IMF in               this situation Nepal borrowed SDR 18.65 million
1961, it had only begun to take assistance since 1976.     from IMF in FY 1985/86 under these arrangements
The first facility used by Nepal was First Reserve         and implemented various policy measures including
and Credit Tranches. Under this facility, countries may    the devaluation of Nepalese currency by 14.7 percent
borrow 25 percent of quota called Reserve Trances,         in November 1985. This amount was around the 50
without requiring any explanation. This amount is          percent of Nepal's quota at that time. Nepal had
part of the country's international reserves. Under        borrowed that amount for the period 12.23.1985 to
this facility, Nepal had borrowed SDR 7.6 million in       4.22.1987.
1976.
                                                           Structural Adjustment facility (SAF)
Compensatory Financing Facilities                              Beginning March 1986,IMF provided the
    This facility was set up by IMF in 1963 to help        concessional financing through Structural Adjustment
member countries that produce primary                      Facility (SAF) for its low income member countries
commodities cope with temporary shortfalls in              to implement economic policies that foster growth
export earnings, including as a result of price decline.   and raise living standard through its advise, technical
An additional component to help countries deal with        assistance and its financial support. The focus of the
temporary rises in cereal import costs also was added      structural adjustment programme was to attain the
in 1981. During 1976/77, Nepal also faced a severe         4-5 percent reasonable growth of the economy. To
drought situation and agricultural production had          keep current account deficit (before grant) to less
declined by nearly 4 percent. To face with this            than 8 percent of GDP, reduce the net domestic
problem Nepal had purchased SDR 20.0 million in            borrowing of the government to less than 1 percent
1978 under this facility.                                  of GDP and maintain price rise at 5 percent by the
                                                           end of the programme. A country eligible for the
Trust Fund Facilities
                                                           SAF facility should prepare the Policy Framework
   IMF has been providing financial assistance on
                                                           Paper (PFP), which includes the quantified targets,
concessional terms to low-income member countries
                                                           or ceilings for bank credit, the budget deficit, foreign
since the mid 1970's. This was the first facility IMF
                                                           borrowings external arrears and international reserve.
has created for its members. Nepal had borrowed
                                                           Nepal also borrowed SDR 26.0 million from
SDR 13.7 million under this facility in 1978.
                                                           10.14.1987 to 10.13.1990 from the SAF and had
Stand by Arrangements (SBA)
                                                           implemented various reform programmes.
   This facility was designed by IMF in 1952 to
provide short-term balance of payments assistance          Enhanced Structural adjustment Facility (ESAF)
for deficits of a temporary or cyclical nature. Such           IMF has been providing concessional lending to
arrangements are made typically for 12-18 months.          help its poorest member countries to achieve external
Drawings under this facility are phased on a quarterly     viability, sustainable economic growth and improved
basis and the release of the amount is made                living standards since the late 1970's.Between 1986
conditional on meeting performance criteria.               and 1999 many developing countries of the world
Repurchase are made 3.75 to 5 years after each             drew on low interest loans under the SAF and its
purchase. In the early 1980's Nepal had faced              successor the ESAF designed the need to help the
rigorous internal and external imbalances. These           IMF's poorest members in their efforts to achieve
imbalances were reflected in low output growth,            stronger economic growth and sustained
huge fiscal deficit, overvalued exchange rate, and         improvement in their balance of payments. Nepal
declining exports. Fiscal deficit had increased from       had faced a 21 percent rate of inflation and current
3.2 percent of GDP in 1980 to 8.6 percent in 1983.         account deficit at 8 percent of GDP in 1991/92.
As a result, Nepal faced balance of Payments deficits      Nepal entered into ESAF in October 1992. It had
of Rs 1.67 billion during 1983-1985. Balance of            received approval from IMF SDR 33.57 million for
payments had registered a deficit of up to 2 percent       a period of three years (May 1992 to April 1995).
of GDP in 1985. The foreign exchange reserve of            Of this approved amount Nepal could only
the country had gone down to less than two months          withdraw SDR 16.79 million.
382    NEPAL RASTRA BANK IN FIFTY YEARS

    These facilities from IMF made significant             (per capita gross national income of $875 of 2001).
contributions to the development efforts in low-           Loans under the PRGF carry an annual interest rate
income countries. But despite substantial assistance       of 0.5 percent with repayments made semiannually
from the IMF and the broad donor community,                beginning 5.5 years and ending 10 years after the
many of these countries did not achieve the gains          disbursement.
needed for lasting poverty reduction. This prompted            HMG also submitted the Letter of Intent,
an intense reexamination of development and debt           Memorandum of Economic and Financial Policies
strategies by the years by governments, international      and Technical Memorandum of Understanding on
organizations and others. At the 1999 joint annual         October 31,2003 requesting for the three years PRGF
meetings of the IMF and the World Bank, ministers          facilities from the IMF in the amount of SDR 49.9
from member countries endorsed a new approach.             million. (10 percent of quota). The first annual
They decided to make country-generated poverty             programme under the PRGF had supported policies
reduction strategies of all IMF and the World Bank         to be implemented over the period July16, 2003 to
concessional lending and debt relief. The PRSP             July15, 2004. In November 24,2003, The Executive
approach initiated by the IMF and the World Bank           Board of the IMF finalized its earlier in principal
in 1999,results in a comprehensive country-based           approval of a three year SDR 49.9 million (about
strategy for poverty reduction. It aims to provide         US $72 million) PRGF arrangements for Nepal. The
the crucial link between national public actions, donor    Executive Board of IMF after completing the first
support and the development outcomes needed to             review of Nepal's economic performance under the
meet the United Nations Millennium Development             three year PRGF arrangement has noticed that
Goals (MDG's) that are centered on halving poverty         Nepal's PRSP continues to provide a sound basis
by 2015.                                                   for achieving higher growth and poverty alleviation.
The Poverty Reduction and Growth Facility                  The main elements of the PRGF supported
(PRGF)                                                     programmes - sound macroeconomic management;
    The Poverty Reduction and Growth Facility              better expenditure prioritization and enhanced
(PRGF), established in 1999, is the IMF's low-interest     efficiency, structural reform in major economic
lending facility for poor countries. Through the PRGF,     sectors and improved governance are geared to
the IMF aims to integrate the objectives of poverty        delivering conditions for sustained growth and
reduction and growth more fully into its operations.       enhancing the pro poor focus of budget spending.
Programmes supported by PRGF are framed around             On October 20,2004, IMF approved Nepal to draw
comprehensive country owned Poverty Reduction              an amount equivalent to SDR 7.1 million (about US$
Strategy Papers (PRSP}. PRSP are prepared by               10.6 million) as a second installment which made the
government with active participation by civil society      total disbursement under the programme to SDR
- including the poor and other development partners.       14.3 million (US$ 21.2 million). The PRSP policy
The targets and policy conditions in PRGF supported        measures aim to push up the real GDP growth rate
programmes are drawn directly from the country's           to 5-6 percent over the medium term and reduce
PRSP. The five core principles of the PRSP                 the poverty rate by 8-10 percentage points (from
approach should be (a) Country-driven, promoting           around 40 percent) in five years. It also aims at
national ownership of strategies through broad based       significant improvements in human development
participation of civil society, (b) Result-oriented and    indicators. The PRSP strategy consists of four pillars;
focused on outcomes that will benefit the poor, (c)        broad based economic growth; social sector
Comprehensive in recognizing the multidimensional          development; targeted programmes for the poor
nature of poverty, (d) Partnership-oriented, involving     and deprived groups and good governance. The
coordinated participation of development partners          PRSP notes that the growth strategy should be rooted
(e) Based on a long-term perspective for poverty           in macroeconomic stability and that a reduction in
reduction. Eligibility of a country is based principally   the domestically financed budget deficit over the
on the IMF's assessment of a country's per capita          medium term would help achieve this goal. The
income drawing on the cutoff point for eligibility to      PRSP outlines plans for financial sector public sector
World Bank's concessional lending                          and governance refor ms to improve growth
                                                                                  INTERNATIONAL RELATIONS      383

prospects. The PRSP acknowledges that achievement           (2003), monetary operation, foreign exchange reserve
of the targeted growth rates would depend on                management (2004), implementation of the large
progress in the peace process, implementation of            taxpayer unit (2003), review of tax policy and VAT
structural refor ms and a favorable external                administration (2003), tax and custom administration
environment. With these factors in mind in the PRSP's       reform (2003), follow-up on the LTO and customs
base case scenario, resolution of political uncertainties   administration reform (2004), redrafting of income
and speedy implementation of reforms are projected          tax laws (2001), multisector statistics mission(2001),
to generate average annual growth of 6.25percent            balance of payments statistics advisor (2002-2003),
over 2002/03 to 2006/07.In the lower case scenario,         producer price statistics (2002-2003), monetary
continued political difficulties and delays in reforms      statistics (2003), etc.
would limit average annual growth rate to 4.25
                                                            Liaison with IMF
percent over this period. Inflation is projected to
                                                               Each member country appoints a governor -
remain around 4.5-5 percent.
                                                            usually the country's minister of finance or the
    Policy actions to achieve its goals are outlined in
                                                            governor of its central bank -and an alternate
the PRSP matrix as;
                                                            governor. It is the board of governors on which all
    (a) Macroeconomic Stability – It is linked to
                                                            member countries are represented, is the highest
prudent fiscal policies as mobilize revenue and reduce
                                                            authority governing the IMF. It usually meets once a
domestic budget financing, prioritize public spending
                                                            year, at the annual meetings of the IMF and the World
through the medium term expenditure framework,
                                                            Bank. The Board of Governors decides on major
conduct monetary and exchange rate policy to
                                                            policy issues but has delegated day-to-day decision
support the exchange rate peg and keep inflation low
                                                            making to the executive board. The Governor of
and maintain balance of payments and international
                                                            NRB acts as the Governor of Nepal to the Fund.
reserve position.
                                                            HMG also nominates a senior official, usually a joint
    (b) Structural Reforms include the financial sector
                                                            secretary, from the ministry of finance, as alternate
reform including the reengineering of NRB,
                                                            governor to the Fund. Every year around September-
restructure state owned commercial and development
                                                            October the IMF and the World Bank host annual
banks and improve loan recovery, public enterprise
                                                            Fund - Bank joint meetings where Finance Minister
reforms, civil service reforms, governance and trade
                                                            and Finance Secretary also take part along with the
(WTO accession)
                                                            NRB Governor. A member country exercises its
    (c) Sectoral policies include improvement in
                                                            options through its Executive Director.
agricultural policies industrial policies and improve
                                                                IMF has nominated a resident representative in
in infrastructure development
                                                            Kathmandu since 1985. Resident representative
    (d) Social sectors include improve in the
                                                            coordinates agenda for discussion between Nepal
educational sector and health sector policies.
                                                            and the Fund whether in regular article IV
    (e) Targeted poverty alleviation programmes
                                                            consultation mission or if the country is under going
include budget allocation for deprived communities
                                                            any fund supported programmes such as PRGF. The
and areas, improve poverty monitoring and increase
                                                            resident representative also attends Aid Nepal
scholarship.
                                                            Consortium (currently called Nepal Development
Technical Assistance and Training                           Forum) meetings in Paris.
   The IMF has provided various technical assistances
                                                            World Bank
to Nepal at its request. Expert advisory support has
                                                                The IMF and the World Bank are sister institutions
been provided in case of various projects and
                                                            in the United Nations system. They have the same
programmes including the cost of living Indices
                                                            international membership and share the same goal
(1977), review of financial system (1984), budget
projection (1984), design and package of tax and            of raising living standards in their member countries.
other revenue measures, financial sector development        Their goal is complimentary with the IMF focusing
programme (1987), bank supervision (1987),                  on ensuring the stability of the international financial
simplification of export procedures (1987), central         system. IMF loans are relatively short term, and
bank and banking reform (2001), monetary policy             funded mainly by the pool of quota contributions
384    NEPAL RASTRA BANK IN FIFTY YEARS

provided by its members. IMF staffs are primarily         also serve ex-officio as Governor and Alternate on
economists with wide experience in macroeconomic          the IFC and IDA Boards of Governors. MIGA
and financial policies. The World Bank concentrates       Governors and Alternate are appointed separately.
on long term economic development and poverty             The Governors admit or suspend members, increase
reduction. World Bank loan is generally long term         or decrease the authorized capital stock, determine
and is funded both by member country contributions        the distribution of net income, review financial
and through bond issuances. The World Bank staffs         statements and budgets, and exercise other powers
are often specialists in particular issues, sectors or    that they have not delegated to the Executive
techniques.                                               Directors.
Purposes of the World Bank                                Boards of Directors
    As mentioned in the Article I of the Articles of         The World Bank Group Boards of Executive
Agreement (amended in February 16, 1989) the              Directors are responsible for conducting the day-
World Bank has the following purposes:                    to-day business of the World Bank. The Boards are
- to assist in the reconstruction and development         composed of 24 Directors, who are appointed by
    of territories of members by facilitating the         member countries or by group of countries. Regular
    investment of capital for productive purposes.        meetings are usually held once or twice a week and
- to promote private foreign investment by means          other meetings are held at various other times
    of guarantees or participation in loans and other     whenever required. The five largest shareholders -
    investments made by private investors                 France Germany, Japan, United Kingdom and the
- to promote the long-range balanced growth of            United States appoint an Executive Director, while
    international trade and maintenance of equilibrium    19 Executive Directors represent other member
    in balance of payments.                               countries.
- to arrange the loans made or guaranteed by it in
                                                          President
    relation to international loans through other
                                                             The Bank's president is, by tradition, from the
    channels so that the more useful and urgent
                                                          United States, which is largest shareholder. The
    projects, large and small alike, will be dealt with
                                                          president is elected for a five-year renewable term.
    at first.
                                                          The president chairs meetings of the Board of
- to conduct its operation with due regard to the
                                                          Directors and is responsible for overall management
    effect of international investment on business
                                                          of the Bank.
    conditions in the territories of members and in
    the immediate post war years ,                        The World Bank Group
    Under the Articles of Agreements of IBRD, to              The World Bank consists of five closely associated
become a member of the bank a country must first          institutions, all owned by member countries. Each
join the IMF. Membership in IDA, IFC, and MIGA            institution plays a distinct role in the mission to fight
are conditional on membership of IBRD.                    poverty and improve living standard. The World
                                                          Bank's group member the International Bank for
Organization
                                                          Reconstruction and Development (IBRD) was
Board of Governors                                        established in 1944 along with the IMF to help
    According to the Bank's Articles of Agreement         Europe recover from the devastation of World War
each member country appoints one governor and             II. After the establishment of the other financial
one alternate governor. Generally, these governors        institutions it has become the wing of the World Bank
are ministers of Finance. Both of them serve a five       which aims to reduce poverty in middle income and
year term and may be reappointed. They are the            creditworthy poorer countries by promoting
ultimate policy makers of the Bank. Under the articles,   sustainable development. Today, it has almost global
all powers of the Banks are vested in the Board of        membership of 184 countries. The success of that
Governors. The Board of governors meets once a            institution led the Bank to turn its attention to the
year at the Bank's annual Meetings. If the member         developing countries. By the 1950's ,a group of bank
of the bank is also a member of IFC or IDA, the           member countries decided to establish that could
appointed governor of the bank and his alternate          lend to the poorest countries on the most favorable
                                                                                 INTERNATIONAL RELATIONS      385

terms. As a result, International Development             has been assisting Nepal in a number of ways, through
Association (IDA), the soft lending window of the         lending in support of development projects and
World Bank, was established in 1960 and now it has        programmes, through macroeconomic policy
164 member countries. It helps the world's poorest        dialogue and advise and by assisting Nepal to finance
countries to reduce poverty by providing interest free    development activities The first World Bank's credit
loan and programmes aimed at boosting economic            of $ 1.78 million was approved for a
growth and improving living standards. IDA lends          telecommunication project from the IDA in 1969.
to those countries that had income less than US$          Since then the Bank has approved credits with a
865 per person in 2002. Some 81 countries are             cumulative total of almost $2.0 billion active credits
currently eligible to borrow from IDA these countries     total $ 302 million as of June, 2004. Since 1970's the
are home to 2.5 billion people half of the total          Bank has funded six road projects which have
population of developing world of which an                supported road rehabilitation and maintenance and
estimated 1.5 billion people survive on incomes of        have helped the government develop sustainable
$2 or less a day. A country must be a member of           funding for the sector. The World Bank financed basic
IBRD before it can join IDA. IDA credits have             and primary education project is strengthening
maturities of 20, 30 or 40 years with a 10-year grace     educational institutions at national, district and school
period before repayments of principal begins. There       levels. The Bank is currently the largest provider of
is no interest charge but carry a small service charge    external assistance in Nepal. Initially much of the
of 0.75 percent on funds paid out. IDA is funded          lending supported in agriculture, irrigation and
largely by contributions from the governments of          infrastructure but increasingly a large part of the
the richer member countries. Their cumulative             lending has focused on the social sectors.
contribution since IDA's establishment to June 2003           In Nepal, the World Bank works with multiple
is US $118.9 billion.                                     development partners, His Majesty's Government,
    The International Finance Corporation (IFC), the      other bilateral and multilateral donor organizations,
other wing of the World Bank, promotes economic           non-governmental organizations (NGO's), the private
development through the private sector. It invests in     sector and the general public-including academicians,
sustainable private enterprises in developing countries   scientists, economists, journalists, teachers and local
without accepting government guarantees. The              people involved in development projects. The Bank's
Multilateral Investment Guarantee Agency (MIGA)           main objective is to provide financing and advice
established in 1988 and now with 164 members help         for projects which are owned and supported by the
to encourage foreign investment in developing             Nepali people and which are a logical part of a
countries by pro guarantees to foreign investors          comprehensive and efficient overall development
against losses caused by non-commercial causes. It        agenda.
also provides technical assistance to countries to            Recently, the World Bank has developed an action
disseminate information on investment opportunities.      plan known as the Nepal Country Assistance Strategy
The International Center for Settlement of                (CAS) covering a period of three years beginning in
Investment Disputes (ICSID) established in 1966 and       2004. The CAS was designed to support the Poverty
now with 140 members helps to encourage foreign           Reduction Strategy of the Government. It is built
investment by providing international facilitation,       around four pillars identified in Nepal's Poverty
conciliation and investment disputes in this way          Reductions Strategy Paper (PRSP's) as:
helping to facilitate the atmosphere of mutual                (a) To achieve sustained and broad based
confidence between states and foreign investors.          economic growth, focusing on the rural economy.
Nepal became the member of IFC, IDA and MIGA              Since economic growth is a engine of poverty
in 1966, 1968 and 1994 respectively.                      reduction, the Bank's assistance focus on removing
                                                          some of the bottlenecks of growth, such as the
The World Bank Group and Nepal                            excessive role of the state, and lack of adequate
   Nepal became the member of the World Bank              infrastructure. The Bank's assistance over the last few
on the same day with IMF. Nepal and World Bank            years has focused on strengthening the quality of
partnership began when it fielded its first economic      public expenditure, the soundness of the financial
mission to the Kingdom in 1963. Since then the Bank       system and the investment climate.
386    NEPAL RASTRA BANK IN FIFTY YEARS

    (b) To accelerate human development through             development of the most populous and fastest
a renewed emphasis on effective delivery of basic           growing regions in the world today. The bank in
social services and economic infrastructure.                addition to providing to loans, equity investment, and
    The standards of education and health directly          technical assistance -has identified five strategic
influence the quality of life and labor productivity        objectives .As such, the bank aims to promote
of the people; the Bank's assistance to Nepal has           economic growth, reduce poverty, improve the status
focused on improving the quality of education and           of woman, develop human resources,
health care. With funding and technical assistance          (including family planning) and help bring about
from the Bank, Nepal is moving towards                      sound management of natural resources and the
decentralized management of education and                   environment.
improving the quality of education.                             The ABD provides its lending arrangements to
    (c) To ensure social and economic inclusion of          its member countries through the Asian Development
the poor, marginalized groups and less developed            Fund (ADF) and through Ordinary Capital Resources
regions.                                                    (OCR). Asian Development Fund is ADB's
    The Bank is working with HMG/N and other                concessional or soft loan window and ADB's donor
development partners in strengthening the policy            member countries provide the fund. ADF loans carry
dialogue reaching out to marginalized groups, which         very low interest rates, and are for the poorest
are often overlooked by existing institutions as            borrowing countries. Ordinary capital resources are
community-based projects, like the Rural Water and          replenished by borrowings from the world's capital
Sanitation Project.                                         market. These loans are made to market interest rates
    (d) To vigorously pursue good governance, both          to better -off borrowing countries. Most of the
as means of delivering better development results           lending of the ADB goes to the public sector, and
and ensuring social and economic justice.                   to governments. It also provides direct assistance to
    To improve governance the Bank has advised on           private enterprises of DMC's through equity
better allocation and release of public funds, greater      investment and loans. Traditionally, agriculture and
transparency and monitoring of public expenditure           rural development – the mainstay of many Asian
and the government's decentralization programme.            economies – have received most ADB support. In
                                                            recent years, however, the social infrastructure sector
Asian Development Bank
                                                            -including health, education, and water supply has
    The first ministerial conference on Asian
                                                            increased in importance. It reflects the ADB's poverty
Economic Cooperation held in Manila in December
                                                            reduction drive.
1963, under the auspices of ESCAP, passed a
                                                                As one-fifth of the population of the Asia Pacific
resolution endorsing a proposal to establish a
                                                            region is still poor and this region still represents the
Regional Development Bank for Asia. The Asian
                                                            two-thirds of the world's poor, the main focus of
Development Bank (ADB) was established in
                                                            the ADB's lending programmes are on poverty
December 1966 with 31 members and its
                                                            reduction. ADB has announced a Poverty Reduction
headquarters in Manila, Philippines. Over the years
                                                            Strategy (PRS) in 1999 under which it adopted
the membership of the bank has grown to 63, which
                                                            poverty reduction as the overarching goal of its
are 45 from Asia and Pacific, and 18 from other
                                                            operation. The strategy is framed in terms of three
parts of the world. It is a multilateral development
financial institution and also is an entirely independent   mutually reinforcing 'pillars' as pro-poor sustainable
international financial institution. But it has close       economic growth, social development and good
working relationship with other international               governance. The pro-poor sustainable economic
organizations through project co financing,                 growth emphasizes the need to stimulate
consultations and regular exchanges of information          environmentally sound economic growth that
about work in the region. The Bank is engaged in            benefits the poor, such as promoting sound
promoting the economic and social progress of its           macroeconomic management and assisting projects
Developing Member Countries (DMC's) in the Asian            that increase employment and boost productivity.
and Pacific region. In its 38 years of operations, ADB      Similarly, the social development pillars include human
has become a major catalyst in promoting the                capital development, population policy, gender
                                                                                INTERNATIONAL RELATIONS      387

equality and social protection, The good governance      of June 30, 2004, total technical assistance
includes support for pro-poor policies, government       commitments consisted of 238 projects for a total
accountability, transparency and anti-corruption.        of about US $ 109.5 million. There were 35 active
    In 2002, the United Nations General Assembly         TA's for a total of about $ 32.4 million. Moreover,
adopted the Millennium Development Goals                 the ADB has been working through its lending and
(MDGs) which set light goals for development and         technical assistance programme to create a policy and
poverty eradications to be achieved by 2015. These       legal environment in Nepal that promote private
goals are consistent with the comprehensive approach     sector development. ADB's assistance to Nepal has
to poverty reduction adopted by the ADB. Overall,        been focused on three sectors, which accounted for
ADB increased its lending volume to the projects         82 percent of its public sector loans. They are social
classified as 'poverty Interventions' or 'Core Poverty   infrastructure (38.7 percent), energy (25.4 percent),
Interventions' by exceeding its 40 percent lending       and agriculture and natural resources (17.9 percent).
target in both 2002 and 2003.                                The Board of Directors of ADB has endorsed
                                                         a Country Strategy Programme (CSP) for Nepal for
Nepal and ADB
                                                         the period 2005-2009. The overarching objective of
    Nepal is one of the 31 founding members of
                                                         the CSP is to achieve sustained poverty reduction by
ADB. Nepal is the 24th largest shareholder in ADB
                                                         fostering more inclusive processes of broad based
among its regional members and 32nd largest
                                                         growth, social development and good governance.
shareholder overall. The number of shares held by
                                                         ADB's programmes during 2005-2007 will focus on
Nepal is 5,202, which is 0.15 percent of total shares.
                                                         assisting the government to promote a greater balance
Total votes of Nepal are 19087, which is 0.44% of
                                                         between different regions of the country and
total membership, and 0.67 percent of total regional
                                                         improve access of the poor to basic services and
membership. Overall capital subscription is US $77.30
                                                         opportunities for advancement. It will also address
million and paid in capital subscription is US $ 5.42
                                                         the needs of the most disadvantaged groups, such
million. The parternership between Nepal and ADB
                                                         as women, ethnic groups, and lower castes. The
began in 1968 with a technical assistance (Grant)
                                                         strategies and sectors prioritized in the CSP are based
followed by a concessional loan of US$ 6 .0 million
                                                         on an assessment of poverty and wide consultations
in 1969 for Air Transport Development. Since then
                                                         with all levels of government, civil society, beneficiary
ADB has become as a key development partner of
                                                         communities, and development partners. The CSP
Nepal and has continued to support development
                                                         proposes lending programmes of $350 .0million
financing, reforms and provide policy advice and
                                                         for the first 3 years (2005-2007),which corresponds
technical assistance. It has remained focused on
                                                         to an average assistance programmes of $117.0
helping the government to reduce widespread
                                                         million per annum consisting of 11 projects. To
pover ty. As of December 31, 2004, total
                                                         complement the lending programmes 26 technical
commitments by the ADB consisted of 104 loans
                                                         assistance projects and five studies are planned for
amounting to US$ 2.1 billion covering projects in
                                                         2005-2007amounting to about $4 million per year.
agriculture, energy and natural resources, finance and
                                                         The TA will support project preparation, institutional
industry, social infrastructure, transport and
                                                         development, training, and managing for
communication and others. Nepal has received all
                                                         development results. For promoting broad based
the loans from the Asian Development Fund
                                                         economic growth ADB has focused on projects on
resources except one small loan ($2.0 million) from
                                                         Transport and Communication, Agriculture and Rural
Ordinary Capital Resources approved in 1970. Of
                                                         Development, Finance and Private Enterprises
these, 81 loans are closed with a total of about $ 1.1
                                                         Development (including small and medium
billion disbursed. As of June 30, 2004, 21 public
                                                         enterprises), Energy and Regional Development. For
sector loans were ongoing with a total net loan
amount of about $ 615.7 million. In addition there       fostering social development it has proposed the
were five private sector loans totaling about $59.0      projects on Education, Water Supply, Sanitation and
million, including three equity investments amounting    Urban Development, and Social Protection. Similarly
to about $3 million. Since 1968 ADB has provided         on promoting good governance ADB has focus its
Nepal with technical assistance in most sectors. As      support for good governance on building the
388    NEPAL RASTRA BANK IN FIFTY YEARS

capacity of key public institutions, especially at the       Objectives
local level. They will deliver essential services, thereby       The objectives of the SEACEN Center as stated
improving the quality and inclusiveness of the public        in the Memorandum and Articles of Association
service and helping combat corruption.                       dated January 27, 1982 are as follows:
                                                                 (a) to promote a better understanding of the
The South East Asian Central Banks Research
                                                             financial monetary, banking and economic
and Training Centre (SEACEN)
                                                             development matters which are of interest to the
    The South East Asian Central Banks Research and
                                                             central banks and monetary authorities of the
Training Center (SEACEN) was established in 1982
                                                             countries in South East Asia or of interest to the
as a legal entity with eight member central banks/
                                                             region as a whole;
monetary authorities of Bank Indonesia, Bank Negara
                                                                 (b) to stimulate and facilitate cooperation among
Malaysia, Central Bank of Myanmar, Nepal Rastra
                                                             central banks and monetary authorities in the area of
Bank, Bangko Sentral ng Pilipinas, Monetary Authority
                                                             research and training.
of Singapore, Central Bank of Sri lanka, and Bank
                                                                 To achieve these objectives, the Center undertakes
of Thailand. The Centre has grown to thirteen
                                                             research into the fields of financial, monetary, banking
members with the inclusion of the Bank of Korea
                                                             and economic development matters and related
in 1990, the Central Bank of China, Taipei in 1992,
                                                             matters, organize and conduct training courses,
the Bank of Mongolia in 1999, the Ministry of
                                                             collect, publish and distribute results of research and
Finance, Brunei Darussalam in 2003 and the Reserve
                                                             studies and such other information related to the
Bank of Fiji in 2004.
                                                             objectives of the Center, arrange and organize
    Besides this full member status, the Center also
                                                             seminars, workshops and conferences, provide
has five central banks/monetary authorities which
                                                             advisory and technical services to the South East Asian
obtained observer status. These are state Bank of
                                                             central banks and monetary authorities, cooperate
Vietnam, Bank of the Lao PDR, National Bank of
                                                             with other institutions to promote the objective of
Cambodia, National Reserve Bank of Tonga and Bank
                                                             the Center and undertake any other activities to further
of Papua New Guinea. This status provides a privilege
                                                             the objectives of the Center.
to attend the annual SEACEN Governor's
Conferences, which is a forum to exchange                    Membership
information, experiences and views on financial,                At the 21st meetings of Board of Governors
monetary, banking and economic developments in               (BOG), it was agreed that admission of new
their countries and in the region as a whole. The            members must be based on consensus and only the
conferences also invite experts from various                 BOG can decide for admitting a new member and
international institutions such as the IMF, BIS and ADB.     new observer at the SEACEN. The BOG approved
The other nine central banks and monetary authorities        the guidelines for consideration that the institution
in the Asia Pacific region have received the status of       should be a central bank or monetary authority or a
invitees to the training activities of the Center. The       government agency performing the functions of a
status has been received by the Central Bank of              monetary authority, the country belongs to the same
Solomon Island, Hong Kong Monetary Authority,                geographical area as most existing members, the
Reserve Bank of Australia, Reserve Bank of New               fundamental character of the SEACEN Center will
Zealand, Bank of Japan, Royal Monetary Authority             not be altered after admission; and the SEACEN
of Bhutan, Central Bank of the Islamic Republic of           groups remains at manageable size.
Iran and the State Bank of Pakistan. The eligibility and
                                                             Organization and Governance
responsibilities of these central banks and monetary
authorities are different depending on their status as          The organization and governance of the
members, observers or invitees. On the SEACEN                SEACEN Center has been guided by the agreement
Board of Governors meetings, only the SEACEN                 of February 3, 1982. In the agreement it is stated
member banks are invited. Only the member can send           that as the BOG is the supreme decision-maker of
their staff to the Center to undertake research studies.     the Center. The Center undertakes and exercises its
The members are obliged to contribute to the annual          powers and discharges its duties under the direction
SEACEN budget on an equal sharing basis.                     and supervision and consultation with BOG. The
                                                                                 INTERNATIONAL RELATIONS      389

policies of the Center, its budget, work programmes,       Administration Division consists of Training
annual reports and accounts require the approval of        Department, Administration Department and
the BOG. The BOG meetings on June 1, 2001 in               Information Technology Unit.
Singapore agreed to appoint an Executive                   Training Seminars and Workshops
Committee (EXCO), which advises the BOG in the                 The training courses conducted by the Centre are
policy, issues concerning the center's activities. The     generally of longer duration, usually more than a
21th SEACEN BOG meetings held in Ulaanbaatar,              week, which are interactive learning events to enhance
Mongolia, has approved the proposal of the                 the capacity building of member central banks. In a
EXCO's Terms of Reference (TOR) and has agreed             seminar the topic is of current interest and discussions
to delegate the EXCO most of the detailed                  are policy oriented in nature. In a workshop, the topic
supervision of the Center. This has allowed the BOG        is generally technical in nature and involves hands on
to concentrate on deliberation of international            practical sessions Participations in the programmes
economic and financial developments and higher-            are by invitation only. Twenty-six central banks and
level policy issues of strategic importance. The BOG,      monetary authorities in the Asia Pacific region are
with the recommendations of the EXCO, makes                invited to the programmes. The Centre started to
decision on the appointment of Executive Director          operate on an informal basis in 1972 by conducting
of the Centre, admission of new members and                training courses at Staff Training Centre of Bank
observers and other matters of strategic importance        Negara Malaysia. At that time it did not have own
to the Centre. The Board of Directors (BOD)                staff, facilities and buildings. The first SEACEN
manages the affairs of the Centre. The BOD consists        course was on 'Management of Financial Institutions'
of Governor (as chairperson) and Deputy Governor           from April 17 to May 13, 1972. Twenty-two
of Bank Negara Malaysia and the Executive Director         participants from Indonesia, Cambodia, Laos,
of the SEACEN center. BOD formulates the policy            Malaysia, Nepal, the Philippines, Singapore, Sri Lanka,
on all matters of the activities of the center and other   Thailand and Vietnam attended the training. Since
management functions. According to the terms of            1972 to Dec ember 2004 the Centre has trained
reference, the Governor of the central bank or             altogether 7062 participants. During this period, the
monetary authority currently chairing the BOG chairs       Centre has conducted 121 training events, 95 Seminars
the EXCO. The rest of the EXCO comprises Deputy            and 57 Workshops. It has been the practice of the
Governors of all member central banks. In addition         Centre to formulate its proposed programmes in
to other works, the EXCO consider and approve              close collaboration with the member central banks,
the funding for the Center's annual budget submitted       so that the programmes of activities is relevant to
by the Executive Director. The budget is then              the current needs and interest of member central
submitted to the Board of Governors for their              banks. In recent years the Center has expanded its
ratification. The EXCO is to meet at least once a          collaboration with other reputable international
year. The Center submits the proposed research and         financial institutions such as IMF, World Bank, ADB,
training programmes and activities for each operating      BIS, Federal Reserve System-USA, Financial Stability
year to the EXCO for review and approval before            Institute (FSI), APEC Training Initiative, Toronto
the end of the preceding operating year. In                Leadership Centre, etc. To establish the Center as a
formulating the research and training programme            separate legal entity commenced in 1973 so that the
and other activities for each operating year, the Centre   Center will be able to recruit international
works in close consultation with the Directors of          professional staffs to carry out its functions and
Research and Training (DORT) of the SEACEN                 activities. On February 3, 1982, the agreement among
member central banks/monetary authorities.                 the central banks of SEACEN countries was signed
    The SEACEN Centre is headed by the Executive           by governors of Bank Indonesia, Bank Negara
Director and composed of two divisions, i.e.,              Malaysia, Nepal Rastra Bank, Central Bank of the
Research Division, and Training and Administration         Philippines, Central Bank of Ceylon, Bank of
Division. Research Division consists of three sections     Thailand and Managing Director of Monetary
as Research Department, Seminars and Publications          authority of Singapore. On January 27,1982, the
Departments and library Unit. Similarly Training and       SEACEN Center was registered as a company limited
390   NEPAL RASTRA BANK IN FIFTY YEARS

by guarantee without a share capital under the           as paid by Nepal in FY 2004 was RM 382,923,
Companies Act 1965 of Malaysia. The first meeting        equivalent to US $ 100,769. From 1972 to Dec. 2004,
of the SEACEN Board of Governors convened in             824 officers from NRB have participated at the
February 1982 in Bangkok.                                various training activities conducted by the Centre.
                                                            Three governors conference and twelve training
SEACEN Trust Fund (STF)
                                                         events have been held in Nepal. The Ninenth (March
   The Board of Governors at the 5th meetings in
                                                         4-6,1994), the 13th(January 16-18, 1978), and the
January 1986 held at Philippines discussed the
                                                         22nd (January 20-21, 1987) SEACEN Governors
proposal to establish a trust fund that would provide
                                                         conference were held in Nepal. The following training
scholarships to SEACEN training participants. The
                                                         events were held in Nepal:
STF deed was signed at the 7th SEACEN Board of
Governors meetings in Singapore on January 22,           Trainings
1988. The board of trustees comprises five members          1. Inspection and Supervision of Financial
with the Governor of Bank Negara Malaysia as the         Institutions (1983 and1990), Examination and
chairman. Three members hold a three year office         Supervision of Financial Institutions (1993), Currency
tenure, and comprise a senior official from Bank         Operation Management (2001), Macro Economic
Negara Malaysia and the governors of two other           Management (2002).
SEACEN member central banks/Monetary
                                                         Seminars
authorities based on a rotational basis. The Executive
                                                            Role of Central Banks in Development Finance
Director of the Center is appointed on an ex- officio
                                                         (1982), Country Risk and Treatment of Non-
basis. The capital base of the STF is derived from
                                                         performing Loans (1983), Current Problems and
contributions from the SEACEN members.
                                                         Issues in International Trade (1987), Domestic
Members contributions has been increased from RM
                                                         Resource Mobilization in the SEACEN Countries
50,000 in the FY 1988/89 to RM 1,349,853 by FY
                                                         (1988), Bank Regulation of Off-Balance Activities in
2003/04. Since 1994 scholarships have been made
                                                         the SEACEN Countries (1993), Monetary Policy in
available to candidates from eligible SEACEN
                                                         a Liberalized Financial Environment (2000), WTO
members to attend training courses. Under the STF
                                                         and Liberalization of the Financial Services Sector
Grant and Scholar Scheme, candidates from
                                                         (2003).
SEACEN member countries with per capita income
of $ 1,000 per annum or less are eligible for            Workshop
scholarships. One scholarship is also allocated each        Regulatory Responses to Derivatives Trading and
year to a candidate for an observer central bank. At     other Financial Innovations (1997).
present, the Governor of NRB is the member of               The Research officials of the member banks also
the STF Board of Trustees.                               got opportunity to work at the Centre So far, NRB
                                                         has deputed six research officers to the Centre.
Nepal and the SEACEN Centre
    Nepal is the founding member of the SEACEN           Asian Clearing Union (ACU)
Centre. The former Governor Mr. Kalyan Bikram                The need for the formation of clearing unions
Adhikary was one of the signatories of the               was felt after the great depression of 1930's Foreign
establishment of the SEACEN Centre in February           exchange shortages, the breakdown of the gold
3, 1982 along with other 6 signatories of the            standard and the collapse of the international capital
Governors of the central banks and Managing              markets forced the governments of the western
Director. Nepal is taking part in all the training/      countries to introduce controls on foreign exchange
activities conducted by the Center. According to the     and foreign trade. In the early 1940's, J.M. Keynes
agreements at the 20th Board of Governors (BOG)          had proposed a International Clearing Union (ICU)
meeting in Singapore, Nepal is sharing equally the       that would operate on a multilateral basis. At the end
core programme budget prepared by the Centre.            of the second world war, scarcity of hard currencies
Based on the agreed formula of cost sharing among        in Europe led the Western European countries to
the member Central Banks and Monetary Authorities,       sign numerous bilateral agreements .In mid-1950, 18
the estimated amount of core programme budget            Western European Countries joined in a multilateral
                                                                                  INTERNATIONAL RELATIONS       391

clearing union known as the European Payments               value of one AMU is equivalent to one US Dollar.
Union (EPU). In this system, at the end of each             Previously, it was equivalent to one Special Drawing
settlement period, the balance would be settled by          Rights (SDR). Settlements of the balances and accrued
US Dollar. Success of EPU encouraged the                    interests are made at the end of each two monthly
developing countries to set up similar clearing unions      settlement period. However, the Board of Directors
in Asia and Pacific Region.                                 may change the length of the settlement periods by
    The Asian Clearing Union (ACU) was established          a decision taken by unanimous vote of all of the
at the initiative of the United Nations Economic and        directors. Each participant is notified from the
Social Commission for Asia and Pacific (ESCAP),             secretary general of its net position at the end of
after considerable rounds of efforts and discussions.       each settlement period and debtors make payments
The draft agreement establishing the ACU was                within four working days of the notice in international
finalized at a meeting of senior officials of the           reserve assets. If the balance of a debtor remains
governments and central banks held at Bangkok in            unpaid after fifteen days from the date it was due,
December 1974 and were signed by India, Iran,               the participant is deemed to have defaulted. However,
Nepal, Pakistan, and Sri Lanka. Bangladesh and              the experience of the ACU's operations from the
Myanmar joined the Union as the sixth and seventh           inception to date shows that there has been no default
members in 1976 and 1977 respectively. The number           by any member in meeting its obligation for the
of the members reached eight after Bhutan signed            settlement of its net position within the stipulated
the agreements in 1999. The ACU started its operation       time. The payments of India with Nepal and Bhutan
in November 1975 with its headquarters in Teheran.          are still considered ineligible to be made through the
    The main objectives of the clearing unions are to       clearing facility. The seventeenth annual meetings of
facilitate payments among member countries for              the Board of Directors established SWAP
eligible transactions, thereby economizing on the use       arrangement whose objective is to extend short-term
of foreign exchange reserves and transfer costs, as         foreign exchange support to any member finding
well as promoting trade among the participating             itself in deficit with any other member during a
countries. The ACU also is a clearing union among           settlement period
other clearing houses/payments operating in various
                                                            Organization
region s of the world.
                                                                Each central bank appoints one Director and one
    The objectives of the ACU as mentioned in its
                                                            Alternate Director to represent it on the Board of
Article of Agreements are:
                                                            Directors for a ter m of two years subject to
    (a) To provide a facility to settle on a multilateral
                                                            reappointed. The board elects a chairman and vice-
basis, payments for current international transactions
                                                            chairman from among its members for a period of
among the territories of participants;
                                                            one year. The Board meets at least once a year. In
    (b) To promote the use of participants 'currencies
                                                            addition, the chairman may call the meetings if
in current transactions between their respective
                                                            requested by two directors or when then chairman
territories and thereby affect economies in the use
                                                            considers it necessary. All the decisions are taken by a
of the participants exchange reserves;
                                                            majority of the votes of all the directors The Board
    (c) To promote monetary cooperation among
                                                            of Directors may make arrangements with a central
the participants and closer relations among the
                                                            bank or monetary authorities of a member to provide
banking system in their territories and thereby
                                                            necessary services and facilities for the operation of
contribute to the expansion of trade and economic
                                                            the clearing facility. The board has accepted the offer
activities among the countries of the ESCAP region.;
                                                            of the central bank of the Islamic Republic of Iran
and
                                                            to act as agent for the Union. The board is authorized
    (d) To provide for currency swap arrangement
among the participants so as to make Asian Monetary         to appoint a Secretary General for a term of three
Units available to them temporarily.                        years. Unlike any other institutions, membership in
    The accounts of the ACU are kept in a common            ACU does not impose any financial obligation or
unit, of account designated as the Asian Monetary           membership quota. All expenses and cost of running
Unit (AMU). With effect from January 1,1996 the             the ACU secretariat has-been covered by the Central
392   NEPAL RASTRA BANK IN FIFTY YEARS

bank of Islamic Republic of Iran as the agent bank      member banks are currently from Australia,
since the inception of the ACU.                         Bangladesh, China, Hong Kong, India, Indonesia,
    Since its inception in 1975, the ACU facilitated    Iran, Japan, Korea, Macao, Malaysia, Mongolia,
smooth and easy trading among member countries          Nepal, New Zealand, Pakistan, Papua New Guinea,
in the region. Unlike any other payments union it has   the Philippines, Singapore, Sri Lanka and Thailand.
not experienced any default. During this period the     Apart from member institutions, central bank
economic policies and the environment in which the      employees from US Canada, Germany, Pacific
ACU was established have changed. There has been        Islands and BIS took part at the training programmes.
a considerable growth in trade among the ACU            Till now, SEANZA has conducted 25 Central
countries. The volume of transactions has increased     Banking Courses. The first SEANZA Central Banking
from US $0.44 million in 1975 to US $ 4546.30           Course was held in Australia at 1957.
million in 2003. In 1975, 20 percent of the total           The SEANZA Central Banking Course is held
transactions cleared in the system and 80 percent was   every two years. The objectives of the Course are:
settled in foreign exchange. Whereas in 2003, 41            (a) to assist in the development and training of
percent was cleared in the system and 59 percent        senior officers for higher central banking executive
settled in foreign exchange. The total ACU              positions;
transactions (one way plus accrued interest) which          (b) to build up knowledge of central banking,
have been routed through the ACU mechanism since        with particular reference to conditions in the
1975 to 2003 amounted to US $ 43707.38 million          SEANZA countries;
of which 52 percent (US$ 22521.26 million) cleared          (c) to promote understanding of the problems
in the system and 48 percent (US$ 21186.12 million)     of the developing countries; and
settled in foreign exchange.                                (d) to foster friendly relations and technical
                                                        cooperation among central banks in these regions.
Nepal and the ACU
                                                            The highest policy making body of the SEANZA
    Nepal is one of the founding members of the
                                                        is Council of Governors who meet every two years.
ACU. The Governor of NRB is the Directors in the
                                                        The Council of Governors meets in between
ACU Board of Directors. The Executive Director
                                                        SEANZA Courses to approve the report on cost
of the Foreign Exchange Management Department
                                                        and sharing. Advisors meeting is held a year before
acts as alternate to the ACU Board of Directors
                                                        the Central Banking Courses and Governors
from Nepal. The officer in charge to look after the
                                                        Symposium. The meeting sets broad parameters for
transactions involving ACU is also deputed from the
                                                        the SEANZA Central Banking Course and to suggest
same department. Since Nepal joined the ACU, NRB
                                                        themes for discussion at the Governors' Symposium.
hosted meeting of Board of Directors on three
                                                        Course expenses are equally divided among the
occasions. In 2003, Nepal make debit (-) of US $6.5
                                                        participants.
million and credit (+)of US$7.3 million, making net
position of 0.8 million under the ACU mechanism.        Nepal and SEANZA Countries
Nepal cleared 89 percent in the system and 11 percent       Nepal joined this association in 1968. The
settled in foreign exchange.                            Governor of NRB takes part at the council of
                                                        Governors. Nepal has successfully conducted the
South East Asia New Zealand and Australia
                                                        fifteenth Central Banking Course at Katmandu in
(SEANZA)
                                                        April-June1985.
    SEANZA was established in 1956 by the central
banks of the five British Commonwealth countries;       Asia Pacific Rural and Agricultural Credit
Australia, India, New Zealand, Pakistan and Sri Lanka   Association(APRACA)
after a meeting in London. The motive behind the           APRACA is an autonomous body having the
establishment of SEANZA was to conduct the              capacity of legal personality with its office premises
intensive and systemic training course of Central       in Food and Agriculture Organization (FAO)
Banking to develop promising officers for further       Regional Office for Asia and the Pacific, Bangkok,
advancement.                                            Thailand. It is an association of government and non-
    Over the years the membership has expanded          governmental, institutions, bodies and agencies in Asia
from five member banks in 1956 to twenty. The           and the Pacific Region involved directly or indirectly
                                                                                   INTERNATIONAL RELATIONS      393

in rural and agricultural credit, in particular, and         Principal Organs and the Agencies
development of rural and agricultural sector in                  (a) General Assembly: It is the highest policy-
general. At the beginning the Association consisted          making body and consists of all APRACA members.
of 28 institutions from nine countries. Presently it         It convenes once in two years to review the past
has more than 55 member institutions from                    performance and decide upon the future direction
23countries.They are from Australia, Azerbaijan,             of the Association. It elects the members of executive
Bangladesh, Cambodia, China, East Timor, India,              committee to oversee its programmes and activities
Iran, Japan, Korea, Kyrgyztan, Malaysia, Mongolia,           for the period of next two years.
Myanmar, Nepal, Pakistan, Philippines, Soloman                   (b) Executive Committee: The executive
Islands, Sri Lanka, Thailand, Uzbekistan and Vietnam.        committee of APRACA consists of 12 members .It
Any government department or governmental agency             is composed of chairman, Vice-chairman, Eight
involved in rural finance and agricultural credit, any       members and two ex-officio members. The Ex-
central bank or monetary authority, any national level       officio members are the representative of FAO and
financial institution, or national level federation or       Secretary General of APRACA..
association of financial institutions actively pursuing          (c) Secretariat: The secretariat is headed by the
rural and agricultural financing and development, any        Secretary General who is responsible for the day-to
national level training or research and development          day administration of the association. The secretariat
institute related to rural finance and agricultural credit   conducts all activities approved by the General
are eligible for membership of APRACA. The                   Assembly. It also coordinates the activities of
establishment of APRACA was first proposed at a              APRACA agencies.
regional seminar on Agricultural Credit for Small                (d) Agencies: APRACA and its agencies are non -
Farmers in Asia on October 1974. Subsequently, rural         profit organization working for public benefit for
finance and agricultural credit institutions of the          raising the standard of living of rural people with
region formally launched APRACA during its first             emphasis on the rural poor through rural and
General Assembly Meeting in New Delhi, India, on             agricultural development in general and rural finance
October 10-14, 1977. Its constitution and by-laws            innovations in particular. These agencies are APRACA
were also adopted during the meeting.                        Centre for Training and Research in Agricultural
    The vision of the APRACA aspires to work for             Banking (CENTRAB) and it is responsible for
rural growth and development, with priority                  conducting training programmes. Its office is located
emphasis on the upliftment of the poor. The mission          in Manila. The training courses conducted by the
is to promote efficiency and effectiveness of rural          Center are classified into Core Courses, Courses on
finance and access to sustainable financial services.        Current Issues and auxiliary courses. The core courses
The strategy is to realize the vision and fulfill the        focus on subject matters relating specifically to rural
mission through innovations in rural finance as well         finances and are offered regularly. The courses on
as accessible and sustainable financial programme.           current issues are conducted on need basis. APRACA
                                                             consultancy Services(ACS), located in Jakarta is the
The Objectives of the APRACA are:
                                                             consultancy ar m of APRACA. It renders
   (a) to stimulate cooperation in improvement and
                                                             consultancy/advisory services to member institutions
planning of financial arrangement for rural and
                                                             ,international and regional agencies as well as other
agricultural development,
                                                             institutions and APRACA Publications (AP) located
   (b) to establish among its members, a machinery
                                                             in Mumbai undertakes the activities of collecting and
for systematic interchange of information on
                                                             editing relevant rural finance materials for
sustainable rural and agricultural financial services,
                                                             publications in APRACA Journal. It also publishes
   (c) to encourage and assist in undertaking inter-
                                                             other technical books on rural finance.
country studies on matters of common interest in
the field of rural finance experts among the members,        Nepal and APRACA
   (d) to provide services related to consultancy,              NRB is the founding member of APRACA.
research and publications in the field of rural finance,     NRB, Agricultural Development Bank of Nepal
   (e) Facilitate cooperation on rural finance projects      (ADB/N), Nepal Bank Limited (NBL), and Rastriya
between the members and donors.                              Banijya Bank (RBB) are members from Nepal. NRB
394    NEPAL RASTRA BANK IN FIFTY YEARS

successfully conducted the 6th General Assembly           financial issues for the mutual benefit of SAARC
meeting on December 8-11, 1986. Similarly the 31st        member countries, and consider any other matter
meeting of the Executive Committee was held at            on the direction/request of the SAARC finance
1994 in Kathmandu. The Governor of NRB                    ministers, council of ministers or other SAARC
inaugurated 44th Executive Committee meetings held        bodies.
in Nepal during 14-18 October 2001.                           The SAARCFINANCE is a permanent body at
                                                          the level of Governors of Central Banks and
SAARCFINANCE
                                                          Secretaries of Finance of SAARC member countries.
    The SAARCFINANCE was established in 1998
                                                          It submits its report to the SAARC Council of
as a regional network of the SAARC Central Bank
                                                          Ministers through SAARC Finance Ministers. Each
Governors and Finance Secretaries. It has held nine
                                                          Central Bank should establish a cell to coordinate
meetings since its inception on 9th September 1998
                                                          the activities of SAARCFINANCE. The SAARC
following the 10th SAARC summit held in Colombo,
                                                          secretaries would assist and coordinate activities of
Sri Lanka. The Ter ms of Reference of the
                                                          SAARCFINANCE. SAARCFINANCE meetings
SAARCFINANCE were approved at the 11th
                                                          of Central Bank Governors and the Secretaries of
SAARC summit held at Katmandu in January2-3,
                                                          Finance is held at least twice a year at the time of the
2002. The Terms of Reference (TOR) include the
                                                          spring and annual meetings of the IMF and the World
structure and the broad objectives of
                                                          Bank.
SAARCFINANCE. According to the TOR, the
                                                              The SAARCFINANCE chair moves in rotation
broad objectives of SAARCFINANCE are to
                                                          with the change of the SAARC Chair. The Governor
promote cooperation among central banks and
                                                          of NRB took over the Chair of the
finance Ministries in SAARC member countries by
                                                          SAARCFINANCE with the change of the SAARC
staff visits and regular exchange of information,
                                                          Chair to Nepal in January 2002. NRB Governor
consider and propose harmonization of banking
                                                          made the presentation at the 23rd SAARC Ministerial
legislations and practices within the region, work
                                                          Meetings held in Kathmandu during August 21-22,
towards a more efficient payment mechanism within
                                                          2002 and at the 24th Ministerial Meeting held in
the SAARC region and strive for higher monetary
                                                          Islamabad during January 2-3, 2004. The formal
and exchange cooperation, forge closer cooperation
                                                          handling over of the SAARCFINANCE Chair from
on macroeconomic policies of SAARC member
                                                          Nepal to Pakistan took place in the 10th
states and to share experiences and ideas, study global
                                                          SAARCFINANCE meetings held on April 24,2004
financial developments and their impact on the region
                                                          in Washington DC.
including discussions relating to emerging issues in
the financial architecture IMF and World Bank and         SAARCFINANCE Meetings
other international lending agencies, monitor reforms         The SAARCFINANCE has held nine meetings
of the international financial and monetary system        since its inception on 9th September 1998 following
and to evolve a consensus among SAARC countries           the 10th SAARC summit held in Colombo. The 9th
in respect of the reforms, monitor international          meeting of SAARCFINANCE governors and
currency and capital flows and to work towards a          finance secretaries was held on, September22, 2003
common SAARC position., evolve wherever feasible          in Dubai, United Arab Emirates. The meeting
joint strategies ,plan and common approaches in           decided among others the coordination of the
international for a for mutual benefit particularly in    SAARCFINANCE be done at the central bank's
the context of liberalization of financial services,      level and it would be the responsibility of the
undertake training of staff of the ministries of          coordinators of the central banks to duly report the
finance, central banks and other financial institutions   activities to the MOF. The meetings also decided that
of the SAARC member countries in subjects relating        the institutions that are under the regulatory purview
to economics and finance, explore networking of           of the central banks could be invited in the activities
the training institutions within the SAARC region         like research, trainings, seminars etc. The matters of
specializing in various aspects of monetary policy        the cost sharing were also left entirely to the countries
,exchange rate reforms, bank supervision and capital      concerned. The multilateral institutions like the World
market issues, promote research on economic and           Bank, IMF, ADB and BIS also could be involved
                                                                                INTERNATIONAL RELATIONS      395

for technical matters in the training and seminar         Agricultural Banking, Pune), Bangladesh (Institute of
programmes.                                               Bank Management in Bangladesh) and Sri Lanka
                                                          (Centre for Banking Studies of CBSL) granted full
SAARCFINANCE Coordinators Meeting
                                                          tuition-fee waivers to the training participants from
    As decided in the 5th SAARCFINANCE
                                                          the SAARC countries.
meeting, the first meeting of the SAARCFINANCE
Coordinators was held in Colombo, Sri Lanka, on           Planned Activities
January 7, 2002. The meeting discussed various               The Central Banks of the SAARCFINANCE
activities as well as future course of action of the      have completed a number of studies and are planning
SAARCFINANCE. The second and third meetings               various seminars on relevant topics. During January
of the coordinators took place in Kathmandu on            2-3, 2004, the 24th session of the council of ministers
August 7, 2002 and August 11, 2003. The meetings          was held in Islamabad which recommended the
generally tried to expedite the issues that were raised   SAARCFINANCE to conduct many activities,
during the SAARCFINANCE meetings.                         especially the study and recommendations on early
                                                          and eventual realization of a South Asian Economic
Seminars and Special Studies
                                                          Union (SAEU).
    The SAARCFINANCE members conducted the
various study, seminars and workshops at different        Bank for International Settlement (BIS)
member countries. Bangladesh Bank conducted two               Established on May 7, 1930, Bank for
seminars on" Global Financial Crisis and Recessions       International Settlement (BIS) is the world's oldest
" in November 1999           and "Micro -Credit           international financial organization which fosters
Operations" in December 21-23,2003 at Dhaka,              international monetary and financial cooperation and
Bangladesh. Reserve Bank of India conducted the           serves as a bank for central banks. The head office is
seminar/workshop on "Supervision of Financial             in Basel, Switzerland, and there are two representative
Institutions' during January 27-30,1999 and "E-           offices: in the Hong Kong Special Administrative
Commerce in India" during November 11-12, 1999.           Region of the People's Republic of China and in
NRB undertook a study on "The Feasibility of Using        Mexico City. The BIS works:
National Currencies in SAARC Trade" in 2000. NRB              (a) As a forum to promote discussion and facilitate
also conducted two seminars on "Issues in Exchange        decision-making processes among central banks and
Rate Management" during February 12-14, 2001 and          within the international financial community
" Promoting Financial Stability: the Role of Central          (b) A center for economic and monetary research,
Banks" during March 15-18,2004. All the                       (c) A prime counter party for central banks in
programmes were launched in Kathmandu. The State          their financial transactions,
Bank of Pakistan (SBP) conducted a seminar on                 (d) Agent or trustee in connection with
"Financial sector Assessment" during October 24-          international financial operations.
25,2002 and a study on "Financial Sector Assessment            The BIS was established in the context of the
"in 2002. The Central Bank of Sri Lanka (CBSL)            Young Plan (1930), which dealt with the issue of the
conducted two seminars on "The Year 2000 Problem          reparation payments imposed on Germany by the
and Regional Cooperation for Business Community           treaty of Versailles following the First World War. It
in the Banking Sector" during July 12-15, 1999 and        was also created to promote central bank cooperation
"Issues in External Sector Management" during             in general. The reparations issue quickly faded,
January 8-9.2002 in Colombo, Sri Lanka.                   focusing the bank's activities entirely on cooperation
    The countries also have the mutual agreements         among central banks and other agencies in pursuit
on staff exchange programme. Under this                   of monetary and financial stability. Since 1930, central
programme all together 134 officers of the member         bank cooperation at the BIS has taken place through
countries have exchange their knowledge at various        the regular meetings in Basel. The BIS was also the
issues at the member Central Banks. Under this            agent for the European Payments Union (EPU)
programme, a number of training institutions in India     during 1950-58, helping the European countries
(The Banker's Training College, Mumbai, The Reserve       restore convertibility after the Second World War.
Bank Staff College, Chennai, The College of               Similarly it has also acted as an agent for various
396    NEPAL RASTRA BANK IN FIFTY YEARS

European exchange rate arrangements, including the          risks. The Basel Committee on Banking Supervision
European Monetary System, which preceded the                (BCBS) plans to implement it by the end of 2006 in
move to a single currency. It has also provided             BCBS member countries.
organized emergency financing to support the                    Over the past few years, the committee has moved
international monetary system when needed. During           more aggressively to promote sound supervisory
1931-33 financial crisis, the BIS organized support         standards worldwide. The committee in 1997
credits for both the Austrian and German central            developed a set of 'Core Principles for Effective
banks. It has also provided finance in the context of       Banking Supervision' in close collaboration with many
IMF-led stabilization programmes for Mexico in              non-G-10 supervisory authorities. To facilitate
1982 and Brazil in 1988.                                    implementation and assessment, the committee in
                                                            1999 developed the 'Core Principles Methodology'.
Basel Committee on Banking Supervision
                                                            The committee's Secretariat is in the BIS at Basel.
     The central bank governors of the group of ten
countries established the Basel Committee at the end        Nepal Rastra Bank and the BIS
of 1974 comprising from Belgium, Canada, France,               The BIS has currently had 55 members central
Germany, Italy, Japan, Luxembourg, the Netherlands,         banks or monetary authorities. All the members are
Spain, Sweden, Switzerland, United Kingdom and              entitled to be represented and vote in the general
United States. Countries are represented by their           meetings. NRB is not the member of BIS, but the
central bank and also by the authority with formal          NRB has prepared the regulatory framework and
responsibility for the supervision of banking. The          Inspection Manual with international standard mostly
committee formulates broad supervisory standards            based on the Basle Core Principles. The manual
and guidelines and recommends statements of best            provides a comprehensive blueprint for an effective
practice so that the individual countries will take steps   super visory system. To provide the skilled
to implement them, which are best, suited to their          supervisors NRB sends its officers to take part in
own national system. The committee reports to the           the trainings and seminars conducted by the BIS and
central bank governors of the group of ten countries        the Financial Stability Institute.
and seeks the governor's endorsement for its major
                                                            Center for International Cooperation and
initiative. One important objective of the committee's
                                                            Training in Agricultural Banking (CICTAB)
work has been to close gaps in international
                                                                The CICTAB was set up in January 1983 by
super visory coverage in pursuit of two basic
                                                            ministry of Agriculture, Government of India as an
principles; that no foreign banking establishment
                                                            autonomous institution to serve as an international
should escape supervision; and that supervision
                                                            forum in agricultural banking as sub regional center
should be adequate. In 1988, the committee decided
                                                            for Bangladesh, Nepal, Srilanka and India. In the year
to introduce a capital measurement system
                                                            1991, the General Council of CICTAB decided to
commonly referred to as the Basel Capital Accord.
                                                            revive the development of CICTAB activities as focal
This system provided for the implementation of a
                                                            center of HRD efforts in the relevant fields for all
credit risk measurement framework with a minimum
                                                            the countries of the SAARC region. It is also expected
capital standard of 8 percent by 1992. Since 1988,
                                                            that CICTAB will provide an effective forum for
this framework has been implemented not only by
                                                            exchange of experience in agricultural banking and
its member countries but virtually all the countries
                                                            related fields between different developing countries
of the world with a active international banks. In
1999, the committee proposed a New Capital                  in Asia and Africa. It conducts international training
Adequacy Framework, which would replace the 1988            programmes for member countries and countries
accord. The proposed capital Framework (Basel II)           of SAARC regions with special focus on cooperative
is likely to exert a strong influence on the behavior       development for experience and information sharing
of internationally active banks-and hence on their          by providing a common platform to the agricultural
lending to developing countries. The revision is            and rural development.
designed to enhance the safety and soundness of the             Participants for CICTAB's training programmes
banking industry worldwide aligning regulatory              and other allied activities are senior personnel in related
capital with bank's credit, market and operational          departments of Government, Central Banks,
                                                                                  INTERNATIONAL RELATIONS       397

Cooperative and rural development financing               in their rural economy and in the various development
institutions, banks dealings with policies and            programmes undertaken by them. Nepal Rastra Bank,
programmes of their respective institutions and           Nepal Bank Limited, Rastriya Banijya Bank,
trainers from national level or regional level training   Agricultural Development Bank and National
institutions concerned with training of personnel         Cooperative Development Board are the members
from Rural Financing and Development                      of this institution. During the period 513 staffs of
Organization.                                             Nepal has been trained from this institution. The
    The major activities of CICTAB are:                   National Workshop to review training arrangements
(a) Organization of National Workshops                    in Nepal was organized on 1988 with Agricultural
(b) Organizations of collaborative programmes             Credit Institute of Agricultural Development Bank
(c) Delegation's visits to member countries and           of Nepal as lead institution. Similarly the delegation
(d) Organization of training courses and other            of CICTAB visit Nepal at the end of the 1992. The
    programmes.                                           objective of the delegation visit was to have an
    During the period FY1983-84 to FY 2003-04,            opportunity of personal dialogue and discussions
CICTAB conducted four national level                      with the various authorities and national level
workshops, two collaborative programmes, five             agricultural banking, cooperative and rural
delegations to different SAARC countries and 98           development institutions. In 1992-93 Ministry of
training programmes and provide training facilities       Agriculture, HMG, Nepal Rastra Bank, and
to 2180 employees, including SAARC and other              Agricultural Development Bank had organized a
countries of Asia-Pacific. Course design and              workshop on Strengthening Training Arrangements
contents of these programmes were prepared by             for the personnel of Agricultural Banking,
CICTAB in consultation with respective                    Cooperatives and Rural Development. Over the last
sponsoring member institutions and their lead             decade, CICTAB and its member institutions in
national level training institutions. Programme           Nepal have been jointly organizing agricultural and
design and contents were revised/modified from            rural financing training courses in Nepal.
time to time to reflect the evaluation feedback and
                                                          Conclusion
to make the courses more relevant to the training
                                                              The Bank represents the Kingdom of Nepal in
needs of the participants, member institutions and
                                                          various bilateral multilateral, regional and international
member countries.
                                                          financial institutions. As a result, it is natural that NRB
Management                                                is associated with the international financial institutions
    The General Council and Managing Committee            that provide financial assistance and trainings and
consisting of representatives from member                 seminars related to it. Nepal has become the 147th
institutions in member countries manage CICTAB.           member of the World Trade Organization (WTO)
The general Council consists of all the National Level    on April 23, 2004. Nepal has made a whole range
Institutions of member countries in the SAARC             of commitments in various sectors. These
region who have subscribed to the membership of           commitments will make effect on trade and payments
CICTAB. Managing Committee consists of                    and naturally the supply of foreign exchange and
representatives of member institutions in the member      the balance of payments. Nepal also has become
countries. The chairman of managing Committee is          the member of The Bay of Bengal Initiative for
the additional Secretary of Ministry of Agriculture,      Multi-Sector Technical and Economic Cooperation
India. The Committee guides the operation and             (BIMST-EC) on January 23, 2004. The member
activities of CICTAB.                                     countries of BIMSTEC have committed to establish
Nepal and the CICTAB                                      the free trade area by 2017. The free trade between
   CICTAB was set up to provide training                  the members will have direct effect on the foreign
programmes for Bangladesh, India, Nepal and Sri           exchange reserve of the countries. So, in the coming
Lanka. The countries of the region participating in       years, the relationships of NRB with the
CICTAB progarmmes have more or less common                international financial institutions will be further
features and comparable experience and problems           enhanced.
398   NEPAL RASTRA BANK IN FIFTY YEARS

References                                          Private Debt Finance for Developing Countries-
Asian Clearing Union-Annual Report -2003               Global Development Finance 2004- World Bank.
Asian Development Bank and Nepal: Nepal Rastra
                                                    SAARCFINANCE Progress Report, October 10,
   Bank, Research Department -2004
Asia-Pacific Rural and Agricultural Credit             1998–April 15, 2004 prepared by International
   Association: October 2001                           Finance Division, Research Department, Nepal
Background on SEANZA: 25th SEANZA Central              Rastra Bank.
   Banking Course 2004, Manila Philippines.         The SEACEN Center Profile 2004, SEACEN
CICTAB : Report of Activities -2003-2004
                                                       Center, Kuala Lumpur, Malaysia
Contemporary Macroeconomics- Eighth Edition,
   Milton H. Spencer and Orley M. Amos, 1993        World Bank Group and Nepal; Nepal Rastra Bank,
40 Years of The Nepal Rastra Bank (1956-1996)          Research Department, International Finance
   Nepal Rastra Bank -1996                             Division-2003
Nepal Rastra Bank Act 1955 and 2002.                www.adb.org
Nepal Rastra Bank Act 1955 and 2002.
                                                    www.bis.org
Nepal: Request for a Three-Year Arrangement Under
   the Poverty Reduction and Growth Facility-       www. imf..org
   October 31, 2003.                                www.worldbank.org
                                                                                OPEN MARKET OPERATIONS       399




                               Open Market Operations
                                             Shiba Raj Shrestha
                                         Chief Manager, NRB, Biratnagar
Introduction                                                           of spending, output, employment and
     The open market operations (OMO)                                  prices with considerable time lags.
is the major instrument of monetary                                          The Nepal Rastra Bank Act, 2002
control around the world. The OMO                                      provides the central bank a greater
allow greater flexibility to the central bank                          operational independency followed by
in the timing and volume of monetary                                   rules of transparency and accountability
operations at its own initiative by                                    in the formulation, announcement and
encouraging association with the market                                implementation of the monetary and
participants and provide a means of                                    credit policy. The Act has also envisaged
avoiding the inefficiencies of direct                                  achieving price stability, balance of
control. The initiation of indirect monetary control       payment stability, financial stability and efficient
is important to the process of economic                    payment system as the basic objectives of monetary
development because direct control tend to become          policy. It has also clearly spelt out that the major
less effective. However, other monetary instruments        instruments of monetary policy could be cash reserve
now in place need to be adjusted and the market            ratio, bank rate/refinance rate and OMO.
infrastructure must be transformed. As the central              The for mulation of monetary policy has
bank of the country, the NRB is solely responsible         undergone momentous shifts over the years. In the
for the formulation and implementation of monetary         early 1980s, the NRB gave special emphasis on
policy. Monetary policy is the means whereby a central     objectives for the monetary aggregates as policy
bank attains price stability in the economy by             guides for indicating the state of the economy. The
regulating the cost and the availability of money (i.e.,   monetary policy was implemented by targeting a
interest rate and credit availability). The formulation    quantity of bank reserves that was based on numerical
of monetary policy involves developing a plan to           objectives for the monetary aggregates. As the NRB
accomplish the goals of stable prices, favourable          reduced its reliance on the monetary aggregates and
balance of payment situation, efficient payment            familiarized its policy decisions on a wide range of
system, full employment and a stable financial             indicators, the implementation strategy shifted
environment in the country. In implementing that plan,     towards bank reserves and money market conditions
the NRB uses the tools of monetary policy to induce        consistent with broader policy goals. Since that time,
changes in interest rates and the amount of money          ongoing and far-reaching changes in the financial
and credit in the economy. Through these financial         system have reduced the value of the monetary
variables, monetary policy actions influence the levels    aggregates as policy guides. Consequently, monetary
400    NEPAL RASTRA BANK IN FIFTY YEARS

policy plans are now based on a much broader range              six months, plus principal at maturity. Till date the
of indicators. However, the monetary aggregates still           Development Bonds, Special Bonds, National Saving
play a useful role in judging the appropriateness of            Certificates and Citizen Saving Certificates are
financial conditions and in making monetary policy              considered as coupon securities. Some of the
plans.                                                          government debt securities are non-marketable and
     No one approach to implementing monetary                   non-interest bearing that could not be sold directly
policy can be expected to prove satisfactory under              to the general public. However, the bulk of
all economic and financial circumstances. The actual            government debt securities are marketable, that is,
approach has been adapted from time to time in                  they can be traded in the secondary market at
light of different considerations and the desire to             prevailing market prices through licensed market
deal with uncertainties resulting from the structural           makers.
changes in the financial system. Thus, it is fair to say
                                                                Relevance and Importance of Open Market
that the current implementation approach is likely to
continue to evolve in response to changing
                                                                Operations in the Monetary Management
circumstances. Regardless of the particular approach,           Process of the Nepal Rastra Bank
implementing monetary policy involves adjustments                    The OMO affect the money supply and related
in the supply of bank reserves and financial market             financial measures through their impact on the reserve
conditions. Among the policy instruments used by                base of the banking system. As a matter of monetary
the NRB, none is more important for adjusting bank              policy tactics in controlling these reserves, OMO
reserves than OMO, which add or drain reserves                  could be conducted in one of two ways. In an active
through purchases or sales of government debt                   way, the OMO are conducted by targeting for a given
securities in the market. Indeed, OMO are the most              quantity of reserves, which allows the price of
powerful and flexible tool of monetary policy.                  reserves (i.e., the interest rate) to fluctuate freely.
     Historically, a central bank can expand or contract        However, in the passive way, the OMO are conducted
the amount of reserves in the banking system and                by aiming at a particular interest rate, allowing the
can ultimately influence the country's money supply             amount of reserves to fluctuate. The developed
by buying or selling government debt securities like            countries, with well-developed and sensitive markets,
treasury bills, development bonds and other financial           normally employ a passive approach, although there
instruments in the market. When the central bank sells          have been exceptions. A passive approach also
such instruments it absorbs money from the system.              appears to be the norm in emerging markets that
Conversely, when it buys it injects money into the              have reached a certain level of sophistication. There
system. This method of trading in the market to                 are advantages to a more active approach in
control the money supply is called open market                  developing countries. However, the absence of
operations. OMO play an important role in steering              efficient interbank markets to transmit the influence
interest rates, managing the liquidity situation in the         of monetary policy might be the reason for an active
market and signaling the monetary policy stance in              approach in the developing countries. Another reason
the economy.                                                    might be that the active approach allows the central
     The NRB's OMO are generally conducted on                   bank to define its policies more clearly, especially
the government debt securities. In the Nepalese debt            when control of inflation is the overriding goal.
market, the government debt securities are divided                   While conducting OMO, the NRB needs to
into two categories, i.e., discount and coupon government       collect figures on the supply of and demand for bank
debt securities. Discount securities comprises all securities   reserves being indifferent to any of the approaches.
with maturity of one year or less and pay only a                An up-to-date flow of data on bank deposits is
contractually fixed amount at maturity, called face             particularly important for implementing policy
value. In this case, the return to investors is the             changes in order to offset undesired trends. Even
difference between the maturity value and the issue             with a passive approach to OMO strategy focusing
value. The treasury bills are classified as discount            on interest rates, the prompt availability of deposit
securities. Coupon securities comprise all securities with      data will enable the central bank to make better
maturity of more than one year and pay interest every           projections of the demand for reserves, helping to
                                                                                OPEN MARKET OPERATIONS        401

judge the effect of OMO on money market                   policy and the economy is established through the
conditions. The NRB would also require estimates          market for bank reserves (i.e., excess deposits held
of other factors affecting reserve supply, such as        by banks and financial institutions at the NRB). The
government deposits, currency in circulation, foreign     commercial banks are at the center of the money
exchange and the float arising from timing differences    market with their customer deposits and their own
between crediting and collecting funds in the central     reserve balances at the NRB serving as the core
bank clearing system. Many of these estimates require     element in the flow of funds. In the market,
close cooperation with the government at a working        commercial banks and financial institutions trade their
level.                                                    non-interest bearing reserve balances held at the NRB
     In practice, the accuracy of reserve estimates       with each other, usually on an overnight basis. The
needs to be reviewed against incoming evidence on         banks and financial institutions facing short of desired
interest rates from the interbank or money market,        reserve positions borrow from others having excess
which reveals the liquidity pressures in the system.      reserve positions. The NRB's monetary policy actions
Interpretation of this information should be              have an immediate effect on the supply of or
supported by continuing contacts with the market.         demand for reserves and the interbank rate, initiating
The designated officers from the NRB should be            a chain of reactions that transmit the policy effects
continually speaking with the market participants in      to the rest of the economy.
an effort to understand the factors influencing market          In making monetary policy plans, the Monetary
conditions and enabling policymakers to better assess     Management Committee (MMC) of the NRB is
market psychology. A short-term market rate may           involved in a complex and dynamic process. The
usefully serve as the primary guideline for OMO.          Monetary Management Committee estimates when
Thus, the prompt collection of statistics affecting the   and to what extent its own policy actions will affect
demand and supply of reserves is very much                money, credit, interest rates, business developments
required. An inadequate statistical base would greatly    and prices. Since the state of knowledge about the
hamper the NRB in its ability to evaluate the money       way the economy works is quite imperfect, the
market rate movements.                                    policymakers' understanding of the effects of various
     For the last many years, the NRB has been setting    influences, including the effect of monetary policy, is
the objectives of maintaining price stability and a       far from certain. Moreover, the working of the
reasonable surplus in the balance of payments for         economy changes over time, leading to changes in
achieving a sustainable economic growth in the            its response to policy and non-policy factors. On top
country. To achieve these objectives, the central bank    of all these difficulties, policymakers may not have
has set up the monetary aggregates namely narrow          up-to-date and reliable information about the
money (M1) and broad money (M2) as intermediate           economy, because of lags in the collection and
targets. These targets are set on the basis of central    publication of data. Even preliminary published data
bank's confidence on their controllability and accurate   are frequently subject to significant errors that become
predictability. These variables have also shown a         evident in subsequent revisions. Meanwhile, the
significant and economically valid relationship with      government's budgetary policies influence the
prices and income, which are also the major objectives    economy through changes in tax and spending
of the monetary policy itself. To influence the           programs. Shifts in business and consumer confidence
intermediate targets, the NRB has used net domestic       and a variety of other market forces also affect saving
assets (NDA) of the monetary authority's account          and spending plans of businesses and households.
and short-term interest rates as operational targets.     In view of all these economic parameters, the NRB
The operating targets are used to influence               could change reserves market conditions by using
intermediate targets, which ultimately helps to achieve   three main instruments, namely the reser ve
the final targets. This process as a whole could be       requirements, the bank/discount/refinance rate and
referred as the monetary management process of            open market operations.
the NRB.                                                        The high level Open Market Operations
     While implementing the monetary management           Committee (OMOC) formed in the Public Debt
process in the NRB, the basic link between monetary       Management Department of the NRB directs the
402    NEPAL RASTRA BANK IN FIFTY YEARS

most flexible and actively used instrument of             allowed the NRB to provide Standing Liquidity
monetary policy to effect changes in bank reserves.       Facility (SLF) to the commercial banks for maximum
Under the Rules on Public Debt Management, 2002, the      period of 5 days on penal interest rate based on
Open Market Operations Committee is empowered             discount rate derived from the regular 91-day treasury
to conduct open market operations effectively for         bills auction. If the NRB aims to follow expansionary
achieving monetary policy targets. The role of the        monetary policy, it reduces price of its credit. The
committee is to coordinate between the monetary           discount rate also has announcement effects that send
and fiscal policy stance and to make the decision for     signals to markets about stance of monetary policy.
the auctioning and issue of government debt securities.   A higher discount rate can be used to indicate a more
                                                          restrictive policy, while a lower rate may signal a more
Decisions, Developments and Status of the
                                                          expansionary policy. The NRB may also determine
Open Market Operations                                    the type of acceptable collateral and quantum of
     As stated earlier, the most important monetary       borrowing to affect banks’ credit allocation.
policy instruments are the reserve requirements,                The NRB started OMO by auctioning treasury
OMO and discount window in the central banking            bills since November 1988. The 91-day treasury bills
perspectives. The reserve requirements consist of         auction system was introduced to mop up excess
reserves of the banking system. The commercial            liquidity in the banking system, which also discovered
banks are obliged to hold certain percentage of their     market oriented interest rates. In that time it was
deposits as balance with the NRB. The reserve             agreed by the government that the treasury bills could
requirement instrument is not flexible and also not       be issued even if there was no need of cash flow
compulsory for other financial market participants.       for the government. However, the interest cost had
An increase or decrease in reserve requirement ratio      to be borne by the NRB. Although the purpose of
makes banks to hold more or less reserves in the          open market operations is to control the liquidity of
NRB. An increase in reserve requirement reduces           the banking system and implement monetary policy,
money multiplier effect, which reduces banks’ ability     these operations also contribute to the sale and
to extend credit and creation of broad money via          purchase of government debt securities. This has,
deposit expansion. However, during the last few           however, contributed to the for mation of a
years, the reserve requirements of the commercial         secondary market for the government debt securities
banks were gradually reduced for increasing the credit
                                                          and pursuit of domestic borrowing policy in
expansion capacity and reducing the daily volatility
                                                          conformity with daily requirements. Generally, the
of overnight interest rates. The reserve requirement
                                                          open market operations policy of the NRB is
instrument is very effective in the case of structural
liquidity shortage or surplus problems in the market.     formed in conformity with the economic policies
     In Nepal the OMO are referred broadly to the         implemented by the government. During the
purchase and sale of government debt securities by        implementation of operations, deviations of the
the NRB for the monetary management purpose.              realized magnitudes of both narrow money supply
Generally, government debt securities are traded in       (M l) and broad money supply (M 2 ), from their
the efficient capital market. They are realized in        predicted values, are taken into account.
voluntary basis and more flexible than other monetary           With the irregular auctions of 91-day treasury
instruments. For example, if monetary authority aims      bills since November 1988, the 182-days treasury bills
to withdraw currency from circulation or decrease         were introduced in July 1989 to mop up excess
the excess reserve in the banking system, it engages in   liquidity in the economy. But until the end of 1990,
open market sales and for an expansionary monetary        these bills were auctioned very irregularly. Till 1991,
policy it buys securities from the market participants.   treasury bill auctions were conducted twice a month,
     The rediscount window is related to the              one for 91 days and another for 182 days. As the
monetary authority’s lender of last resort role. As       yields were market oriented, the treasury bills were
such, the NRB may lend reserves to banks and              popular financial instruments in the money market.
financial institutions on the bank rate for 180 days.     The NRB has also started issuing Nepal Rastra Bank
On the same way, the current monetary policy              Bonds since December 31, 1991 to mop up excess
announcement for the fiscal year 2004/05 also             liquidity of the economy arising from the widening
                                                                                   OPEN MARKET OPERATIONS       403

fiscal deficit of the government. The issue of NRB           corresponding treasury bills. On the other hand, the
Bonds was continued till July 1994 to squeeze excess         NRB injects liquidity in the economy through the
liquidity through indirect monetary instruments. The         outright purchase of treasury bills in the secondary
outstanding issue of NRB Bonds reached Rs. 5.39              market at the penal rate, where the rates were fixed
billion in mid-July 1994. The conduct of OMO has             by adding two hundred basis points to the yield curve
had two important implications for the monetary              determined rates. The repo facility for seven days
management process. The NRB was able to partly               maturity was also provided to the investors of the
attain internal price stability due to the heavy injection   treasury bills to meet their short-term liquidity
of treasury bills and NRB Bonds in the economy,              requirement. The repo rate was also fixed at the penal
which was able to squeeze monetary expansion. On             rate by adding fifty basis points in an average of
the other hand, the open market sales of treasury            weighted average discount rate of the latest four
bills and NRB Bonds pushed up money market                   auctions of the 91-day treasury bills. However, all
interest rate structure, which had helped in correcting      these provisions pertinent to OMO were abolished
the negative real interest rate.                             on July 19, 2004 through the announcement of new
     During the course of time, the issues of 182-           monetary policy guidelines for FY 2004/05.
day treasury bills were dropped and new treasury                  Under the previous system, the prices in outright
bills of 364 days were issued in mid-July 1994 to            sales/purchases and repos were determined by the
mop up excess liquidity of the economy created by            NRB. However, with the announcement of new
the widening fiscal deficit of the government. In            monetary policy for FY 2004/05 on July 19, 2004,
addition, 28-day and 182-day treasury bills were also        the NRB started arranging auctions for outright sales/
introduced through auctions, since 11 September              purchases, repos and reverse repos. The purpose of
2004, to provide additional financial instruments to         this procedural change was to allow the prices to be
the investors. The issue calendar was first ever             market oriented. In doing so, it was envisaged that
publicized through the bank's website on August 20,          the prices would follow a stable trend and reflect
2003 with all pertinent information. The issue calendar      the real market conditions. An important procedural
was made public with an objective of making the              change in the reverse repo transactions occurred when
government domestic debt management simpler and              the system changed to an auction system since July
transparent for attracting the investors to invest in        19, 2004. These changes had helped the NRB to
government debt securities and ease the short-term           conduct OMO more frequently and effectively. The
liquidity management for them. All of these measures         NRB has conducted OMO sometimes together with
had helped the NRB to conduct effective OMO.                 the interbank money market and the foreign exchange
     Until mid-July 2004, the OMO were conducted             market and sometimes alone to manage the liquidity
under the rules set by the Open Market Operations            in the market in accordance with the monetary policy
Committee, which established a portfolio of                  stance. This has immensely helped to preserve the
government debt securities for tap sale, outright sale/      stability of the markets. The NRB has also used
purchase and repos. As per the prevalent rule, the           OMO extensively during the liquidity squeeze resulting
quantity of sale and purchase of treasury bills in the       from adverse economic situations.
secondary market was determined on the basis of                   Since the start of the OMO, it is merely guided
yield curve. Under these provisions, the NRB fixes           by the liquidity position of the economy. The desired
the rates based on the market, which ultimately              level of liquidity in the economy is adjusted either by
determines the quantum of treasury bills in the              increasing the liquidity level through outright
secondary market transactions. The NRB used to mop           purchases of treasury bills or through repurchase
up excess liquidity through outright sale of the             agreements (repo) or by decreasing the level of
treasury bills in the secondary market provided the          liquidity through outright sale of the treasury bills or
quotes of commercial banks were below the yield              through reverse repurchase agreements (reverse
curve determined rates. The NRB was also absorbing           repo). The weighted average discount rates (or
liquidity through the tap sale of treasury bills. The        auction/interest rates) for OMO reflect the liquidity
rates on tap sale were determined by deducting ten           condition of the economy. The OMO of the NRB
basis points in the weighted average discount rate of        ensured a reallocation of liquidity level in the
404    NEPAL RASTRA BANK IN FIFTY YEARS

economy and also enabled the commercial banks to          to mop up the excess liquidity from the commercial
manage their investment portfolios rationally.            banks. On the contrary, the open market purchase
     For the last one-decade, OMO were being used         auction and repo auction had been used to provide
as the flexible short-term monetary instrument. The       liquidity to the commercial banks.
auction of treasury bills in primary as well as                 Since FY 2004/05, the NRB has also provided
secondary market and repo auctions are being              Standing Liquidity Facility to the commercial banks
undertaken under the conduct of open market               for maximum period of 5 days to meet their short-
operations since the beginning of FY 2004/05.             term liquidity requirement. At the moment, the
According to the new system, the quantity of outright     quantum of the Standing Liquidity Facility has been
sale/purchase, repo and reverse repo auctions in          determined at fifty percent of the holding of treasury
secondary market are determined by the NRB based          bills and development bonds by the commercial
on the Liquidity Monitoring and Forecasting               banks. The quota of total Standing Liquidity Facility
Framework (LMFF) and also the trends of monetary          has been set for each of the commercial banks on
targets. The NRB mops up liquidity through outright       the revolving basis. However, this facility has been
sale of treasury bills in the secondary market when       provided only to the commercial banks at their
the regular auctions indicate very low discount rate,     initiative.
whereas it injects liquidity through outright purchase          As the Standing Liquidity Facility is the alternative
of treasury bills. The market, based on the quantities    to the secondary market sale of treasury bills and
fixed for such transactions, will determine the           inter-bank market borrowing, the rate on such facility
secondary market discount/interest rate.                  has been fixed at a penal rate. As such, the Open
     Till July 18, 2004 the commercial banks were         Market Operations Committee has fixed the rate by
taking initiative for the open market transactions.       adding two hundred basis points on the latest weighed
After announcement of new monetary policy for             average discount rate of 91-day treasury bills with a
FY 2004/05, the NRB is taking such initiatives on         view to check the misuse of the facility and prevents
the basis of liquidity position in the economy as         adverse effect on secondary market and inter-bank
indicated by the LMFF. These new provisions of            transactions. This new policy guideline has envisaged
open market operations have helped to set up more         that the rate of regular auction would remain as a
market-determined transparent process in the              floor rate in the short-term money market, whereas
monetary management and also contributed                  the rate determined under the Standing Liquidity
significantly in the development of government debt       Facility would act as the ceiling rate. These two rates
securities market.                                        would create a tunnel/corridor rate at which the inter-
     The primary objective of monetary policy for         bank transaction rate is expected to fit around (Table
FY 2004/05 is to maintain price stability and to          1).
consolidate the balance of payment. The inflation               During the conduct of effective OMO, the NRB
has been targeted at 4.0 percent while the balance of     has issued the treasury bills amounting to Rs. 21.95
payment surplus has been projected at Rs. 5.50 billion.   billion through the Outright Sale and Rs. 5.30 billion
The excess liquidity of commercial banks had been         through the Tap Sale for absorbing excess liquidity
taken as the operating target of monetary policy for      in the economy during FY 2003/04. On the other
FY 2004/05. In order to monitor and forecast short-       hand, the NRB has purchased treasury bills
term liquidity position, the LMFF has been made           amounting to Rs. 16.21 billion for providing liquidity
operational since the beginning of the current FY         to the economy in the same period. Likewise, the
2004/05. The treasury bills with different maturities,    NRB has provided temporary liquidity facility to the
viz., 28 days, 91 days, 182 days and 364 days were        commercial banks amounting to Rs. 51.40 billion
transacted through outright purchase/sale in the          through the Repo transactions during FY 2003/04
secondary market. However, priority had been given        (Table 2).
                                                                With the initiation of the new OMO modality,
to the issue of short-ter m treasury bills for
                                                          the NRB has mopped up excess liquidity of the
influencing the overnight interbank rate and to make
                                                          long-term nature amounting to Rs. 11.70 billion
the open market operations more effective. The open
                                                          from the banking system during first six months
market sales and reverse repo auction had been used
                                                          of the current FY 2004/05 through the auction of
                                                                                                       OPEN MARKET OPERATIONS           405

 Table 1
 Conduct of Open Market Operations in Nepal Rastra Bank
 (For FY 2003/04)
                            No. of Trade                                                               Trading Amount (Rs. in Crore)

                 Outright                         Sale                    Outright                                     Sale
 Mid-Month      Puchase       Repo    Outright    Tap        Total        Purchase           Repo        Outright         Tap        Total

 August                0          3         32       0         32                 -           66.60         510.90          -        510.90
 September             7         32         24       2         26             43.00          832.28         200.50      45.00        245.50
 October               9         27         22       6         28            329.00          675.91         281.73     226.00        507.73
 November              6         13         34       0         34            124.80          227.26         357.94          -        357.94
 December             11         13          8       0          8            162.00          386.66          80.00          -         80.00
 January               3          8         12       0         12             73.71          240.75         155.00          -        155.00
 February              1         33          3       2          5             45.00        1,029.47          70.00      40.00        110.00
 March                 5          7          7       0          7            141.00          134.90          79.00          -         79.00
 April                 0          0          2       6          8                 -               -          55.00      50.00        105.00
 May                   0          3          3       1          4                 -          122.00          65.00       5.00         70.00
 June                  0          4         22      10         32                 -          141.55         270.00      79.00        349.00
 July                  8         27          8       8         16            702.76        1,283.22          70.00      85.00        155.00
 Total                50        170        177      35        212          1,621.27        5,140.60       2,195.07     530.00      2,725.07
 Source: Public Debt Management Department, Nepal Rastra Bank.



Table 2
Conduct of Open Market Operations in Nepal Rastra Bank
(For the First Half of FY 2004/05)
                                  No. of Trade                                            Trading Amount (Rs. in Crore)

              Outright                Outright                             Outright                      Outright
              Purchase        Repo        Sale   Reserve                   Purchase           Repo           Sale    Reverse
               Auction      Auction   Auction      Repo        Total        Auction         Auction      Auction       Repo         Total

August                                       2                        3               -                        65                  123.500
September                                    2                       10                                        65                  337.445
October                                      6           2           14                                       955         150    1,516.330
November             1            1                                  47         4.96             105                             1,693.643
December                          1                                   8                          161                               397.250
January                                      2           1            3                                        85         257.     342.000

Total                1            2         12           3           85         4.96             266         1,170        407    4,410.168
Source: Public Debt Management Department, Nepal Rastra Bank




outright sales of treasury bills. Meanwhile, it was                       The quantum of treasury bills auction indicates that
able to squeeze short-term liquidity through the                          the OMO were able to manage the liquidity in the
auction of reverse repo of treasury bills amounting                       economy in line with the attainment of the monetary
to Rs. 4.07 billion during the first six months of the                    policy targets.
current FY 2004/05. On the other hand, the NRB                            Modus Operandi of Open Market
has injected long-term liquidity on the economy                           Operations in the Nepal Rastra Bank
through the auctions of outright purchase of                                   The OMO involve the buying and selling of
treasury bills during first six months of the current                     government debt securities and central bank securities
FY 2004/05 amounting to Rs. 0.05 billion and                              in the open market by the central bank. However, in
injected short-term liquidity in the economy through                      the Nepalese context, the OMO are only the buying
the auction of treasury bills repo of Rs. 2.66 billion.                   and selling of treasury bills in the secondary market
406    NEPAL RASTRA BANK IN FIFTY YEARS

in order to expand or contract the amount of money         Table 3
in the banking system. The purchases of government
debt securities inject money into the banking system               Impact of Open Market Operations
and stimulate growth while sales of securities do the
opposite. As such, the NRB could offset swings in                NRB Purchases                    NRB Sells
reserves caused by changes in the public's demand                  Securities                     Securities
for cash and numerous other factors through the
effective conduct of OMO. The NRB's goal in using                Bank Reserves                  Bank Reserves
                                                                   Increase                        Decline
this principal tool of monetary policy is to adjust
liquidity in the economy through the short-term
                                                               Available Loanable              Available Lonable
interest rate, i.e., the rate at which banks borrow              Fund Increase                  Fund Decrease
reserves from each other.
     According to the section 45 of the Nepal Rastra              Interest Rate                  Interest Rate
Bank Act, 2002, the NRB may conduct OMO against                     Decline                        Increase
debt securities issued by the government or bank
itself with outright purchase/sale of securities,          and its monetary policy plans for the current fiscal
repurchase (repo) and reverse repurchase (reverse          year. The report on monetary policy is based on a
repo) agreements. The OMO are conducted with               comprehensive review of the economic and financial
the objective of effectively regulating the money          situation of the country. The report reviews a wide
supply and liquidity in the economy within the             range of indicators for determining the course of
framework of monetary policy targets. The conduct          monetary policy and includes specific annual growth
of OMO including its procedures, conditions, the           ranges for money and debt aggregates, consistent
amount of issue, the time of issue, the type of            with expectations for inflation and output. The report
instruments, the interest rates and the maturity date is   also discusses about the foreign exchange market
deter mined by the high level Open Market                  development, domestic financial market
Operations Committee headed by the Deputy                  developments and open market transactions in
Governor of the NRB. The Committee also consists           government debt securities.
of representatives (Joint Secretary) from the HMG/              The domestic policy directives indicated in the
N, Ministry of Finance, Executive Directors of             monetary policy announcement guides the modality
Research Department, Banks and Financial Institutions      of OMO. For example, if the short-term interest
Regulation Department, Banking Office and Public           rate is persistently above the intended level, the Open
Debt Management Department. The Director of                Market Operations Committee would expand the
the Public Debt Management Department serves the           supply of reserves to restore the appropriate reserve
Committee as a member secretary.                           market conditions, thereby bringing down the interest
     The NRB, in the scope of OMO, may issue               rate to the intended level. To implement these policies,
monetary bills/bonds for its own account and behalf.       the Public Debt Management Department of the
However, matters such as the prevention of the             NRB would have to translate the monetary policy
monetary bills/bonds from being a permanent                directives into the operating objectives. The detailed
alternative investment tool and the limitation of the      forecasts of the LMFF serve as the core elements
issuance of the bills/bonds to promote the                 for judging reserve conditions for the effective
effectiveness of OMO shall be taken into                   conduct of OMO.
consideration. The OMO shall be conducted only                  As advised by the LMFF, the OMO is conducted
for monetary policy purposes and shall not be              with buying and selling of government debt securities
conducted to provide credit to the government, to          in the secondary market in which previously issued
public establishments and institutions. The sequential     government debt securities, especially the treasury
impact of the OMO conducted by the NRB could               bills, are traded. When the NRB buys securities from
be illustrated in the following diagram.
                                                           the commercial banks, it pays by crediting the bank
     Each year, in mid-July, the Governor of the NRB
                                                           account of the investors at the NRB. Since this
makes an announcement of the monetary policy,
                                                           transaction involves no offsetting changes in reserves
which focuses on the performance of the economy
                                                                                  OPEN MARKET OPERATIONS        407

at other banks, the rise in the reserves of the bank       disruptions, are essential for the effectiveness of
increases the aggregate volume of reserves in the          OMO. The government debt securities do not bear
monetary system. When the NRB sells securities to          credit risk and so they are the most suitable
banks and financial institutions, the reser ve             instruments for OMO. These characteristics of the
consequence is exactly the opposite in which the           government debt securities market enable the NRB
payment by the banks and financial institutions            to buy and sell quickly at its own convenience and in
reduces their reserves.                                    any amount that may be required to keep the supply
     By and large, the seasonal swings in the public's     of bank reserves in line with policy objectives.
currency holdings are the dominant source of short-             The NRB uses two general approaches to add
run currency variation. Some of these swings               or drain bank reserves through changes in the
represent intra monthly patterns reflecting such routine   portfolio of government debt securities in the system.
transactions as payments of salaries and other social      When significant reserve shortages or excesses are
spending. Others result from the effects of somewhat       expected to persist for a relatively long period, the
longer seasonal cycles on business activity during the     NRB may make outright purchases or sales of
year. For example, currency in circulation rises           government debt securities of its holding that
substantially during the festive season, from early        permanently affect the size of the monetary system
September-to-October end and much of this bulge            and the supply of reserves. Aside from the long-
reverses in the following month. Most short-term           term upward trend, most of the time reser ve
variations in currency movements are reasonably            surpluses/shortages are expected to be short-lived,
predictable, since they follow recurrent seasonal          either because seasonal factors are expected to be
patterns. Meanwhile, the NRB attempts to offset            offset or because the outlook for reserves is uncertain.
recurrent contractions and expansions in reserves          In these cases, the NRB undertakes transactions that
associated with seasonal swings in currency through        only temporarily affect the supply of reserves. The
its OMO. If the NRB did not do so, banks and               NRB uses repurchase agreements to add reserves
financial institutions would be compelled to adjust        and reverse repurchase agreements (matched sale
their reserve positions by lowering or raising their       purchase agreement) transactions to drain reserves
investments and short-term loans. Such actions would       on a temporary basis. Such temporary transactions
cause significant fluctuations in the interbank rate and   are designed to minimize fluctuations in the overall
other short-term rates and could lead to serious           supply of reserves. They are used routinely and much
market disturbances.                                       more frequently than are outright transactions.
     The reason for creating the Monetary                       Generally, the NRB (Public Debt Management
Management Committee at the NRB was to avoid               Department) conducts outright transactions in the
the undesirable effects of seasonal swings in the          market through auctions in which the commercial
public's currency holdings. However, the OMO is            banks are requested to submit bids to buy government
required, not only to offset seasonal and other short-     debt securities from the Public Debt Management
lived influences on the supply of bank reserves, but       Department or offers to sell government debt securities
also to deal with changes in bank and financial            of a particular type and maturity. While awarding the
institutions' demand for reserves. Specifically, in        bids, the Public Debt Management Department selects
managing the supply of bank reserves, the NRB              bids with the highest prices (lowest yields) for its sales
would make appropriate adjustments so as to create         and offers with the lowest prices (highest yields) for
money market conditions to be consistent with the          its purchases. Typically, the outright operations are
desired monetary policy objectives. Thus, the OMO          arranged for delivery of the government debt securities
have both defensive and dynamic aspects.                   within the next day. The timing of outright transactions
     It is noteworthy that the NRB normally conducts       is driven primarily by the expected persistence of
its OMO in the government debt securities market,          excesses or shortages in reserves. The exact timing of
which is the broadest and most active of Nepalese          such operations also considers market conditions as
financial markets. The breadth and depth of this           the NRB attempts to avoid rapidly rising or falling
market, as evident in its capacity to accommodate all      market rates and other possible events resulting in
types of transactions without distortions and              market volatility.
408    NEPAL RASTRA BANK IN FIFTY YEARS

     The NRB uses short-term repo auctions with           Instr uments used in the Open Market
banks to add reserves on a temporary basis. Under         Operations
the repo arrangement, the Public Debt Management               In the absence of an active secondary market in
Department buys treasury bills from commercial            government debt securities, OMO are conducted in
banks that agree to repurchase them at a specified        the primary market. Typically, such operations include
price on a specified date. The added reserves are         auctioning newly issued government debt securities
extinguished automatically when the repos mature.         to absorb reserves or auctioning central bank credit
It is much more convenient for the NRB to inject          to provide reserves. The much used OMO involve
large amounts of reserves on a temporary basis            the issue of new government or central bank securities
through outright purchases. Repos allow the NRB           in order to absorb excess liquidity. If the central bank
to respond quickly when reserves fall short of desired    offers new treasury bills to absorb reserves, it should
levels and they can smooth the pattern of reserves        be considered as a monetary operation only if the
for the maintenance period by meeting needs for           incoming funds are not available to government for
particular days. Moreover, transaction costs for repos    spending. The cleanest approach in this regard is to
are very low and the acceptable collateral is the         set the funds aside in a special account created purely
treasury bill. The distribution of repo transactions      for purposes of monetary policy. This approach
among commercial banks is determined by auction           would ensure that bank reser ves are reduced
in which banks bid for a specific amount of repos         permanently by the operation. If the surplus of
at a specified bid price. With all the offers arranged    reserves is overestimated, the central bank could buy
in descending order of bid price, the Public Debt         back the securities before maturity, leaving the special
Management Department accepts offers that carry           account balance unchanged. Such repurchases before
the lowest bid prices up to the desired amount.           maturity, perhaps followed by subsequent resale,
     The OMO from one day to the next are closely         could have the additional advantage of helping to
related. In its every auction, the NRB responds to        develop a secondary market.
the market with the pertinent information. It also             The OMO, by issuing special securities, is of most
takes into account the implications of its own            practical use when the banking system is having excess
immediate past operations. The NRB faces                  liquidity. These securities can be bought back before
considerable risk that it might add or drain more         maturity and resold. They can also be employed to
reserves on any given day than specified, which may       adjust the variation of liquidity pressure. But they do
cause the short-term rate to move away from the           not provide the same flexibility as OMO in the
desired level. To minimize this risk, the NRB             secondary market. In the absence of an active money
responds cautiously to the projections of large           and interbank market, the central bank is
uncertain reserve shortfalls or excesses. Nevertheless,   underprivileged of ongoing information about actual
the Public Debt Management Department does add            and emerging liquidity conditions, which makes
or drain reserves as indicated by the LMFF. Usually,      planning of the timing and size of operations more
the consequences of any such actions can be               difficult. The special issue, guaranteed by the
remedied quickly, since revised information and
                                                          government, may help strengthen and diversify the
operations of the previous day are routinely
                                                          central bank's balance sheet.
factored into the daily reserve picture. As mentioned
                                                               In view of the monetary policy guidelines for
above, the aim of OMO is adjusting the reserve
                                                          FY 2004/05, the instruments of OMO could be
level, money supply and liquidity in the economy.
                                                          categorized as outright purchase, outright sale,
When the NRB decides to realize, it announces the
                                                          repurchase agreements (repo) and reverse repo.
relevant infor mation before the auction day.
                                                          Although the outright purchase and repo injects
Generally, the NRB publishes the auction notice in
                                                          liquidity into banking system, the outright sale and
the daily newspaper (Gorakhapatra) prior to the
                                                          reverse repo withdraws liquidity from banking
auction day and also release the information from
                                                          system.
the website. Bids are accepted till 3.00 p.m. on the
                                                               Repos and reverse repos are ideally suited for
stipulated auction day and the settlements are done
                                                          offsetting short-term fluctuations that affect bank
on the next day.
                                                          reserves. They are also useful for offsetting large shifts
                                                                                 OPEN MARKET OPERATIONS        409

in liquidity caused by a gesture of capital inflows or     As a result of the first leg of repo transaction, the
outflows, which can be expected to become the              banking system’s reserves increase. In the forward
dominant tool for open market operations. The              date (second leg), the NRB sells government debt
outright purchases and sales of treasury bills in the      securities at predetermined price so that the reserve
secondary market are also used to provide or absorb        level in the system decreases. At the moment, the
reserves on a more permanent basis. They are also          maturity period of repo transactions is 7 days.
considered an important instrument of monetary
                                                           Outright Sale
control. A brief description of each instruments used
                                                                Outright sale is the reverse of outright purchase
in OMO are highlighted as below.
                                                           and it is realized when there is structural or permanent
Outright Purchase                                          excess liquidity in the economy. The Open Market
      The OMO through the outright sale of treasury        Operations Committee decides the type of treasury
bills are realized when there is structural or permanent   bills that need to be sold. Then the NRB declares its
liquidity shortage in the economy. If this is the case,    intention to the commercial banks through the auction
the Open Market Operations Committee decides on            notice. The commercial banks that want to buy
the kind of treasury bills that to be purchased. The       specified securities may participate in the auction and
Public Debt Management Department declares its             offers their bids. The Public Debt Management
intention to the market participants through the           Department evaluates offers by considering desired
auction notice. The commercial banks that want to          or planned amount of outright purchase and
sell specified securities may participate in the auction   announces results. The auction winners’ bank accounts
and offers their bids to the NRB. The NRB evaluates        in the NRB are debited and the NRB's investments
commercial banks' offers by considering desired or         in relevant securities accounts are credited. As a result
planned amount and announces results. Auction              of outright sale, the banking system’s reserves
winners' bank accounts in the NRB are credited and         diminish permanently.
NRB's investments in relevant securities accounts are
                                                           Reverse Repo
debited. As a result of outright purchase, banking
                                                                As the name demonstrates, this operation is
system’s reserves increase permanently.
                                                           reverse of repurchase agreement. Reverse repo is
Repurchase Agreement (Repo)                                realized when there is temporary excess liquidity in
     Repo is realized when there is temporary liquidity    the economy. Reverse repo is also forward transaction
shortage in the economy. Repo is a forward                 that it consists of spot sale of an asset and
transaction and it consists of spot purchase of an         simultaneous forward purchase of the same asset.
asset and simultaneous forward sale of the same            Repo rate is the difference between sale price and
asset. In that framework, repo can be thought of as        purchase price of the related government security.
collateralized lending. The repo rate is the difference    The repo rate and purchase date would be
between purchase price and sale price of the related       determined in the spot date (purchase date). If the
government security. During the repo transaction,          NRB aims to decrease the banking system’s reserves
repo rate and sale date would be determined in the         temporarily, it declares reverse repo auction to the
spot date (purchase date). If the NRB aims to              market participants via the auction notice. The
increase the system's reserves temporarily, the Public     commercial banks that want to purchase specific
Debt Management Department declares repo auction           government debt securities from the NRB may
to the market participants through the auction notice.     participate in the auction and offer their bids. The
The commercial banks that want to sell specified           Public Debt Management Department evaluates
securities to the NRB may participate in the auction       market participants’ offers by considering desired or
and offers their bids. The Public Debt Management          planned amount of reverse repo purchase and
Department evaluates offers by considering desired         announces results of reverse repo auction. Auction
or planned amount of repo purchase and announces           winners’ bank accounts in the NRB are debited and
results of repo auction. Auction winners’ bank             the NRB's relevant securities accounts are credited.
accounts in the NRB are credited and the NRB's             As a result of first leg of reverse repo transaction,
investments in relevant securities accounts are debited.   the banking system’s reserves decrease. In the forward
410    NEPAL RASTRA BANK IN FIFTY YEARS

date (second leg), the NRB purchases government            market could be viewed as a prelude to the evolution
debt securities at predetermined price so that the         of active secondary market.
reserve level in the system increases. At the moment,           The focus of monetary policy is to provide
the maturity period of reverse repo transactions is 7      adequate liquidity to support economic recovery and
days.                                                      to avoid the build up of inflationary pressure. With
                                                           a view to facilitating more effective management of
Coordinated Efforts of the Government and
                                                           market liquidity and to achieve its monetary policy
the Central Bank in Conducting Open                        objectives, the NRB moved to more active OMO
Market Operations                                          since August 2004. The key features of the new
     The government decisions on debt management           OMO system are very frequent auction to inject or
and cash balances with the central bank obviously          absorb liquidity. This has also helped to establish an
have an impact on the use of OMO. Sometimes the            interest rate corridor formed by the repo and reverse
government can facilitate the operations. At other         repo rates. Under this system, the volume of liquidity
times, they can complicate the task. All the time, the     to be injected or absorbed under OMO is decided
government and central bank work together on these         by Open Market Operation Committee with the feed
issues, though with varying degrees of tension and         back of the liquidity condition indicated by the LMFF
power. On pure debt management decisions, the              based on the monetary policy stance and market
government in most cases makes the final decision,         liquidity situation.
with the central bank serving as its agent. The central         Since the commencement of more active OMO,
bank normally has a bigger say in areas where              the NRB has conducted repo auctions very frequently
governmental operations have a more direct impact          as there was excess liquidity in the market. The NRB
on bank reserves. Whatever the relationship, OMO           also began conducting outright sales to absorb
will be the most effective monetary instrument where       liquidity on a longer-term basis. It has also offloaded
the central bank has control over factors that affect      the government debt securities under its holding for
the reserve base of the banking system.                    OMO during December 2004 to mop up liquidity
     For the effective OMO, it is particularly             as its net domestic assets portfolio had dwindled due
important for the central bank to be able to influence     to the performance criteria set in the Poverty
the fluctuations of the government's operating balance     Reduction Growth Facility (PRGF) for Nepal.
with the bank, which affect the supply of bank                  When the NRB tightens monetary policy by
reserves. It is unusual for the central bank to be given   draining bank reserves through open market sales
substantial discretionary power over government            of government debt securities, the inter-bank rates
deposits, but there are exceptions. However, the           and other short-term interest rates rise more or less
government may allow the central bank to use its           immediately, reflecting the reduced supply of bank
excess cash balance, stood in excess of the specified      reserves in the market. Sustained increases in short-
ceiling, for redemption of non-marketable securities.      term interest rates lead to lower growth of deposits
     As an economy grows, financial markets can be         and money as well as higher long-term interest rates.
expected to broaden and deepen, but experience             Higher interest rates raise the cost of funds and have
shows that the pace and pattern of market                  adverse consequences over the time for business
development may need guidance from the monetary            investment demand. This is the conventional money
and government authorities. The associated                 of "interest rate channel" of monetary policy
development of open market policy instruments              influence on the economy. A firming of monetary
tends to occur in two stages. First, there is a shift      policy also may reduce the supply of bank loans
away from direct controls toward use of open               through higher funding costs for banks or through
market operations in the primary market through            increases in the perceived riskiness of bank loans.
auctions of new issues of securities. Later, there will    Similarly, non-bank sources of credit to the private
be a further shift toward the use of fully flexible        sector may become scarcer because of higher lending
two-way operations in existing securities as active        risks associated with tighter monetary condition. The
secondary markets develop. The OMO in primary              reduced availability of loans may have negative effects
                                                           on aggregate demand and output. This is the so-
                                                                                OPEN MARKET OPERATIONS        411

called "credit channel" that may operate alongside             The initial link between monetary policy and the
the interest rate channel. Higher interest rates and      economy occurs in the market for bank reserves.
lower monetary growth also may influence economic         When the monetary policy influences the demand
activity through the "wealth channel" by lowering         for and/or supply of reserves at commercial banks,
actual or expected asset values. For example, rising      the effects are transmitted to the rest of the economy.
interest rates generally tend to lower bond and stock     Therefore, one should understand the function and
prices, reducing household net worth and weakening        structure of bank reserves to know how monetary
business and household spending may suffer.               policy is related to the economy. Before the
     By causing changes in interest rates, financial      implementation of OMO, the central bank should
markets and the exchange rate, monetary policy            have information and statistics about demand for
actions have important effects on output,                 and supply of bank reserves.
employment and prices. These effects work through              Generally, the demand for reserves consists of
many different channels affecting demand and              required reserves and excess reserves. The required
economic activity in various sectors of the economy.      reserves are a fraction of predetermined deposits,
Changes in the cost and availability of credit,           which is also called cash reserve ratio (CRR),
reflecting changes in interest rates and credit supply    determined by the NRB. The total required reserves
conditions, are the most important sources of             increase or decrease with the level of deposit volume
monetary policy effects on the economy. All these         subject to required reserves and required reserve ratio.
changes, in due course, affect economic activity and      Generally, licensed bank and financial institutions hold
prices in various sectors of the economy.                 reserves in the form of vault cash and required
                                                          reserve balances with the NRB. In addition to
Outcomes and Impact of Open Market
                                                          required reserves, some banks and financial institutions
Operations                                                might prefer to hold additional balances in the form
     The monetary management process in Nepal has         of excess reserves that is the second component of
been improved by recent introduction of monetary          demand for reserves. Many factors affect supply of
instruments, especially the effective OMO through         reserve in the system. Such factors are changes in
auctions of outright sale, outright purchase, repo and    currency holdings of the public and the government's
reverse repo of treasury bills. The limit on access to    cash balances at the NRB. Currency demand is the
the Standing Liquidity Facility has been reviewed and     largest factor that requires reserve injections to the
reduced the potentiality of injecting liquidity so that   system. Changes in currency demand may come from
the monetary targets are achieved. The new monetary       swings in business activity and seasonal factors such
approach has been able to provide market oriented         as payments of salaries or shopping at festive and
interest rates through the effective OMO. The             holiday seasons. Most short-term variations in
monetary management process in Nepal has                  currency movements are predictable and the NRB
significant effects on employment and output in the       attempts to offset seasonal swings in currency through
short run; however, it affects primarily prices in the    the OMO. As such the disturbing volatility in the
long run. The short-run variability of deposits results   short-term interest rates is eliminated.
in part from the influence of cyclical and other short-        In general, the government maintains its bank
term developments in the business activity. These
                                                          account at the NRB for making and receiving
developments go hand-in-hand with short-run
                                                          payments. An increase in the bank balance absorbs
changes in interest rates, which affect credit flows
                                                          reserves from system and decrease in these balances
and the holdings of various earning assets, such as
shares, bonds, debentures and time/saving deposits,       injects reserves to banks. The NRB also considers
relative to currency and demand deposits that yield       government cash balances during the daily liquidity
no income. Seasonal adjustments and related               management. Therefore, the high-level cooperation
procedures can be applied to sort out recurrent           between the NRB and government should be
patterns of deposit movements. The actual behaviour       ensured. When forecasts of reserves indicate that the
of deposits and credit in the economy reflects the        supply of reserves will probably continue to need
interaction of banks and financial institutions,          adjustment, the NRB may engage in outright
businesses, households and the NRB as well.               purchases or sales. When projections indicate only a
412    NEPAL RASTRA BANK IN FIFTY YEARS

temporary need to alter reserves, the NRB may              the life of the OMO. Any fall in the price of a security
engage in the repo/reverse repo transactions that only     would pose a credit risk to the central bank.
temporarily affect the supply of reserves. As a result     Therefore, the NRB may demand securities with a
of these temporary transactions, fluctuations of           greater market value than the amount of liquidity
reserves may be diminished. The accuracy of                provided.
estimation may be judged by using money market                  To reach monetary ends by implementing OMO
and/or interbank interest rates. Changes in these may      needs restrictions on discount window monetary
reveal pressures in the market. In addition to that,       instrument. Otherwise, OMO could not be used as
the NRB would be communicating continuously to             the basic monetary instrument for controlling bank
the market participants with the assistance of Open        reserves. For example, banks may get funds from
Market Operations Committee designated traders.            discount window when a contractionary OMO has
So, the NRB provides information about liquidity           been realized. However, the discount window policies
level or abnormality in the market as soon as possible.    could be used to discourage short-term borrowing
The banks and financial institutions may trade reserves    from the NRB. In totality, the NRB should be able
held at the NRB among them, usually overnight. The         to determine the linkages among monetary
benchmark rate of interest charged for the short-          instruments very carefully. Reserve requirement
term use of these funds is called the interbank rate.      instrument may assist OMO of the NRB. Thus, the
Changes in that rate reflect the basic supply and          NRB may send more clear signals by using OMO
demand conditions in the market for reserves.              with reserve requirement.
Equilibrium is satisfied in the reserves market if
                                                           Problems and Challenges in the Conduct of
demand for bank reserves is equal to supply of
reserves. Allowing to interest rate changes and/or
                                                           Open Market Operations
changes in reserve amount in the system may eliminate           The OMO should be undertaken in markets that
disequilibria in the reserves market.                      may not be entirely ideal but are at varying stages of
     As described earlier, the NRB supplies reserves       development toward a deregulated, competitive
to the banking system mainly in two ways, i.e., lending    system. In such cases, OMO may need to be limited
through discount window and buying government              in size or employed only periodically. A central bank
securities from the market. In the first case, loans are   would be able to function more effectively if markets
provided to banks and financial institutions at a          perceive that its portfolio of assets is highly liquid and
discount/penal rate. Discount window facilities are        essentially risk free. The markets most suitable for
uniquely suited to the task of meeting the temporary       flexible OMO is normally those where short-term
liquidity needs of individual banks. But OMO are           instruments are traded. Well-developed markets are
better suited to implementing the short-term               characterized by a large and continuous volume of
adjustments to the availability of aggregate reserves      trading by a variety of participants, including
that are necessary in conducting monetary policy. In       government, financial institutions and other businesses.
addition to that, adjustments to the basic discount        These sectors present the best opportunities for
rate can be important in signaling and conducting          effective OMO. These are the markets for government
monetary policy.                                           and central bank securities, for interbank debt and for
     The main rationale for reserve requirements was       short-term instruments issued by financial institutions
ensuring insurance to deposit withdrawals. But the         and other corporate entities, including commercial
rationale for reserve requirements changed over time.      paper and bank certificates of deposit.
At present, in addition to its old rationale, reserve           If the amount of government debt is low, the
requirements assist in conduct of OMO by helping           OMO should be conducted on the private money
to ensure a stable, predictable demand for reserves,       market instruments. If a significant government debt
which increase the central bank’s control over short-      market does not exist, a central bank may decide to
term interest rates.                                       create a similar balance sheet effect by developing
     The OMO may create trading loss for the central       debt instruments of its own or through the use of a
bank. For example, the market prices or the discount       special government issue employed only for monetary
rates of eligible debt securities may change during        policy purposes.
                                                                                OPEN MARKET OPERATIONS         413

     The government debt securities market is             The NRB should prefer to operate in a transparent
generally regarded to be free of credit risk and          market that trades continuously, where
therefore the best medium for OMO. Unstable               communication of its operations is prompt and in
political and economic conditions may make it             which its purposes are well understood. Thus, it
impossible to maintain a viable market for issuing        should take steps to help achieve these goals by
government debt securities. Political stability and a     promoting an interbank market, designing proper
sustained government record of meeting interest           market instruments and trading infrastructure,
payments and redemption schedules are essential to        providing financing facilities, establishing criteria for
the use of OMO. Apart from a failure to meet such         dealing with the open market function, collecting and
contractual obligations, a government securities          disseminating statistics and encouraging safe payments
market can also dry up if the central bank pursues        and clearing mechanism.
an inflationary policy that drives investors out of the        Apart from these, the issue of the NRB bills/
market by eroding the real value of outstanding debt.     bonds should be initiated especially for the purposes
Thus, keeping inflation within acceptable bounds is       of monetary policy. Choosing between the two types
also a vital precondition for effective OMO.              of instruments, i.e., the NRB securities and
     With these backdrops, the NRB's new approach         government securities, therefore depends mostly on
in monetary policy implementation should focus on         institutional and market considerations. The issue of
adjusting short-term liquidity and allow for a larger     the NRB securities may be useful to conduct OMO,
degree of market determination of interest rates. A       when the government securities are not allowed to
more active management of banking system liquidity        use in conducting open market operations. However,
would therefore require a strategy for the central        the development of an active government debt
bank's stance of monetary policy which should be          securities market would be delayed, rather than
implemented mainly through conducting OMO.                stimulated, by large-scale issues of the NRB's own
                                                          bills/bonds. Thus, the government should take it
Corrective Actions, Policy Options and Future
                                                          seriously that the issue of the NRB's bills/bonds
Agenda for Conducting Effective Open Market
                                                          would be complicating its policies on determining
Operations by the Nepal Rastra Bank
                                                          cost of debt management and segmenting a thin debt
     For conducting efficient OMO both the NRB
                                                          market.
and the government need a reliable marketplace for
                                                               If the OMO are taken as the principal policy
government debt securities, where participants feel
                                                          instrument for the monetary management process
secure that counter parties will perform according
                                                          in the country, other monetary instruments obviously
to their obligations and which is transparent enough
                                                          need to be given less importance, particularly the
to encourage wide participation. To obtain its
                                                          discount window, where the banking system can
objectives through OMO, the NRB should establish
                                                          obtain reserves on its own initiative simply by
performance standards for participants. This is also
                                                          borrowing from the NRB. For OMO to be effective,
the natural focal point for market surveillance through
                                                          limitations need to be placed on the access of banks
gathering statistics and publishing market aggregates.
                                                          to borrowing from the NRB at the discount window.
The NRB may not wish to go beyond these functions
                                                          Without such limitations, OMO could not be used
by assuming direct regulatory and oversight
                                                          as the principal monetary instrument for controlling
responsibilities, which may unduly tax its limited
                                                          bank reserves and overall financial conditions. The
personnel resources as well as a loss of credibility
                                                          discount window should therefore be designed to
creating rumors in the government debt securities
                                                          make access to the NRB's credit less attractive in one
market, as they sometimes do.
                                                          way or another, perhaps through a high penalty rate
     A demarcation between monetary management
and debt management may serve a better monetary           or restrictive guidelines in providing Standing
management process. The general public would tend         Liquidity Facility. Restrictions on the discount window
to rely on the NRB as bearing some responsibility         need, however, to be handled with care. If a penalty
for markets in which it operates. For this reason, the    rate is set well above current market conditions, the
NRB should take steps that help rationalize the           system might not react quickly enough to
market's architecture and enhance its performance.        unanticipated liquidity demands. The regulations that
414   NEPAL RASTRA BANK IN FIFTY YEARS

restrict access to the window have to permit smooth      securities in the form of promissory notes and the
adjustment when reserve shortages occur.                 practice of secondary market transactions with an
     In a tight monetary policy implementation           unofficial endorsement should be abolished.
period, borrowing from the NRB for very limited               To have a clear separation between monetary
periods allows banks to make more orderly portfolio      and fiscal policies, it is most desirable that all the
adjustments. Such short-term borrowing at the            government debt securities should be issued through
discount window, viz., Standing Liquidity Facility,      the auctions. The non-interest bearing and non-
should be differentiated from longer-term structural     marketable government debt securities should also
borrowing, i.e., Refinance Facility, which allows        be paid by the government or made marketable with
emergency long-term advances to banks and financial      market-oriented coupon to avoid any potential
institutions in severe operating difficulties. Other     conflict between debt management and monetary
adjustments may also be needed, depending in part        policy needs. The timely initiation of planned auction
on the particular strategy adopted for conducting        of long-term government securities would also help
OMO.                                                     to develop a competitive and deregulated market
     It is always better to implement monetary policy    system. This also avoids pressure on the NRB to
through OMO in the secondary market, mainly in           facilitate primary market issues at a predetermined
the form of repos and reverse repos. The repos           rate.
provide temporary financing of reserve shortages              To minimize the credit, delivery and settlement
and surpluses but do not directly influence demand       risks associated with the securities transactions and
and supply in the security that serves as collateral.    to make OMO more effective, the NRB should
Most positively, repos tend to enhance liquidity in      institutionalize Primary Dealers System (PDS) for
the underlying securities by helping to develop a more   selecting trading counter parties for its OMO. As
active secondary market. The use of repos with a         such, the NRB could also encourage market
short maturity would encourage participants to           development by setting down ground rules for
develop as many alternative sources of short-term        parties with which it deals. The primary dealers must
lending and borrowing as possible. Repos can be          be either commercial banks or highly capitalized
used in various maturities, although short-term          financial institutions or big corporate discount houses.
operations tend to dominate. If the repos have           The primary dealers should be able to handle large
become the main instrument, the OMO should be            orders efficiently, quickly and safely. If a primary
undertaken through informal auctions on a daily basis    dealer fails to meet the specified standards, the NRB
with maturities generally overnight. However, outright
                                                         should discontinue its trading relationship with that
transactions run a high risk of dominating the market
and impeding further development, when secondary         dealer. The primary dealers have an obligation to
markets are still comparatively thin. As the repos is    make reasonable bids and offers when the central
the most flexible and convenient form of financing,      bank enters the market, as well as in the regular
it could also be seen as an effective instrument for     auctions. If the market participants are very few, the
increasing market liquidity and helping to smooth        creation of a primary dealer system may be more
the way to broader market development.                   problematic and impractical. In order to avoid
     HMG/N should have greater interest in               charges of favoritism and market collusion, the
competitive trading, given that the cost of national     number of primary dealers should be fairly large.
debt should fall as government securities become         By establishing such dealers, the NRB would be in a
more liquid. For this purpose, an active interbank       stronger position to encourage dealers to establish
market is particularly important because it helps in     better market-making standards, such as minimum
clarifying the timing and volume of OMO. The NRB         transaction sizes for dealing at quoted prices. Of
should also encourage market practices conducive         course, ongoing rapid technological changes would
to competitive trading. It could encourage a             also influence the best approach for the NRB to take
computerized system of bids and offers for securities    toward market structure and its own counter parties.
that protects anonymity. To foster market                     The NRB is the focal point for collection and
transparency, it should also discourage trading from     dissemination of financial market statistics. The
outside the established markets. As such, the issue of   process of data collection, including daily figures on
                                                                                 OPEN MARKET OPERATIONS          415

positions, transactions volume and financing by type      Concluding Remarks
of issue, should begin perfectly at the very earliest          The monetary policy formulation is not a simple
stages of development. These figures provide the          technical matter. It is clearly an art that greatly depends
basis for surveillance. Thus, the NRB should be able      on experience, expertise and judgment. In the last
to release aggregate data on market activity as quickly   few years, OMO have become the most important
as possible in order to enhance market transparency.      monetary instrument in the monetary management
Publication should be timed with sufficient lag,          process of the NRB. It is realized in voluntary basis
perhaps a week, depending on the instrument, to           and more flexible than other monetary instruments.
avoid market overreaction.                                However, the NRB conducted OMO sometimes
     The NRB should also encourage the market             together with the foreign exchange market to manage
to set delivery and payment standards. There              the liquidity in the market in accordance with the
would not be effective market functions without           implemented monetary policy and to preserve the
reasonable assurance that securities would be             stability of the markets.
delivered on time and paid for as agreed. The                  Generally, the NRB uses OMO extensively during
speed and reliability of the clearing and payments        the liquidity squeeze. The OMO of the NRB ensure
systems depend on the market's technical capacity         a reallocation of liquidity level in the economy and
and institutional arrangements. The NRB can also          also enable banks to manage their securities portfolios
work together with the government to introduce            rationally. In the near future, the NRB would continue
up-to-date technology in the government debt              to use OMO frequently during the inflation targeting
securities market. Such technological developments        monetary policy implementation. The Open Market
would be to introduce a book-entry (scripless)            Operation Committee would still set interest rates
system to record security ownership and a                 for different maturities and the Public Debt
simultaneous delivery-versus-payment procedure            Management Department will be engaged in
through the central bank's deposit accounts as the        transactions that yield desired liquidity level in the
central depository. The initiation of secondary           market in order to achieve inflation target. The OMO
market transaction through the Nepal Stock                will remain a major instrument to ensure equilibrium
Exchange (NEPSE) would also be the milestone              in the demand and supply of bank reserves.
in the development of a vibrant capital market in              In practice, the OMO would function most
Nepal. To accommodate all these features, the             effectively when the authorities abide by a clear
prevailing rules and regulation for the transaction       division between debt management and monetary
of the government debt securities and open                policy operations. This usually involves an agreement
market operations are not sufficient. Thus, there         to neutralize the monetary effect of the government's
is a greater need of having appropriate legal,            cash balance with the NRB or to delegate substantial
regulatory and infrastructure base through proper         control over it to the NRB. Virtually, the debt
amendments in the prevailing rules and regulations.       management decisions are made with ongoing input
     For ensuring most economic, efficient and            from the NRB, both informally and through formal
effective OMO in the NRB, the issue calendar of           committee structures.
government debt securities should be announced                 Reliable market for government debt securities
immediately after the announcement of government          is essential for OMO. The market participants should
budget. The issue calendar should be followed strictly    feel secure that counter parties will perform their
with the least amendments. Moreover, the notification     obligations. Therefore, the NRB should establish
of the forthcoming OMO should be released to the          performance standards for market participants. It
market, at least, three days before the auction. Last     should aim to operate in a transparent market in which
but not the least, as the backbone of the OMO, the        trading is done continuously. It should communicate
people involved in the operations should be well          about the proceedings of the OMO to the
educated, trained with sufficient exposures on debt       participants with clear purposes. The NRB needs to
and monetary management. The management theory            develop interbank market, design market
of "right man in the right place" should strictly be      instruments, devise trading infrastructure, provide
followed for this purpose.                                financing facilities, establish criteria for dealing with
416    NEPAL RASTRA BANK IN FIFTY YEARS

its open market function, and collect and disseminate     NRB. Various Issues. Nepal Rastra Bank Samachar.
statistics. It should also ensure required technical          Kathmandu: NRB.
assistance and develop electronic transfer and            NRB. 2002. Nepal Rastra Bank Act, 2002.
settlement mechanism.                                         Kathmandu: NRB.
                                                          Paudel, Dandapani. 2004. "Monetary Policy and
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Basyal, Tula Raj. 2004. “Nepal's Debt Sustainability:
                                                              Bank Samachaar.
   An Analysis." Rastra Rin Khabarpatra 2, March/
                                                          Rawal, Tilak. 2004. Monetary Policy for FY 2004/05.
   April.
                                                              Kathmandu: NRB.
Borio, Claudio E.V. 1997. “The Implementation of
                                                          Sellon, Gordon H., Jr. and Stuart E. Weiner. 1996.
   Monetary Policy in Industrial Countries: A
                                                              "Monetary Policy Without Reserve Requirements:
   Survey."Bank for International Settlements Economic
                                                              Analytical Issues." Federal Reserve Bank of Kansas
   Papers 47.
                                                              City Economic Review 81:4.
Fama, Eugene F. 1980. "Banking in the Theory of
                                                          Shrestha, Shiba Raj. 2004. "Effective Domestic Debt
   Finance." Journal of Monetary Economics 6.
                                                              Management in Nepal." Nepal Rastra Bank
Freedman, Charles. 1990. “Implementation of
                                                              Samachar.
   Monetary Policy and Market Operations." Reserve
                                                          Shrestha, Shiba Raj. 2004. “The Concept of Scripless
   Bank of Australia.
                                                              Government Debt Securities." Rastra Rin
Gray, S., G Hoggarth and J. Place. 2000.
                                                              Khabarpatra 2, March/April.
   “Introduction to Monetary Operations." Handbook
                                                          Shrestha, Shiba Raj. 2004. "The Role of Primary
   in Central Banking, 10.
                                                              Dealers System in the Development of Domestic
Laidler, David. 1999. "The Quantity of Money and
                                                              Government Debt Securities Market in Nepal."
   Monetary Policy." Bank of Canada Working Paper.
                                                              Rastra Rin Khabarpatra 3, September/October.
Leith, C., and S. Wren-Lewis. 2000. "Interactions
                                                          Bank of England. 2000. “The Transmission
   between Monetary and Fiscal Policy Rules."
                                                              Mechanism of Monetary Policy.” Bank of
   Economic Journal 110.
                                                              England Publications.
McCandless, G. T., and W.E. Weber. 1995. "Some
                                                          Bank of England. 2002. “The Bank of England’s
   Monetary Facts." Federal Reserve Bank of Minneapolis
                                                              Operations in the Sterling Money Markets.” Bank
   Quarterly Review 19.
                                                              of England Publications.
Meulendyke, A. M. 1998. "U.S. Monetary Policy and
                                                          Woodford, M. 2003. Interest and Prices: Foundations of
   Financial Markets." Federal Reserve Bank of New
                                                              a Theory of Monetary Policy. New Jersey: Princeton
   York.
                                                              University Press.
Nepal Rastra Bank (NRB). 1996. 40 Years of the Nepal
                                                          World Bank and International Monetary Fund. 2001.
   Rastra Bank. Kathmandu: NRB.
                                                              "Developing Government Bond Markets." July.
                                                                                             INTEREST RATE      417




                                             Interest Rate
                                           Nara Bahadur Thapa
                                          Director, Research Department

Introduction                                                            First, they indicate the conditions in
    Nepal Rastra Bank (NRB) is the                                      financial markets. Hence, they are used to
Central Bank of the Kingdom of Nepal.                                   assess the financial conditions in the
The Bank was founded over 49 years ago                                  economy. Second, they are indicators of
and is entering the fifth decade of its                                 expectations about inflation. If the long-
establishment. Over the years, NRB has                                  term interest rates are lower than that of
initiated a number of policy changes.                                   short term, they can be inferred that the
Alongside the theoretical and economic                                  market participants have lower inflation
developments of the countr y, the                                       expectations. This aspect is crucial for the
domestic monetary policy has experienced                                conduct of monetary policy. Third,
a number of shifts. A shift in interest rate policy        interest rates are indicators of the result of monetary
regime is one of them. Almost fifty years ago, Nepal       policy actions. Therefore, interest rate data can be
had a tightly administered interest rate regime.           used to analyze the ex-post monetary policy stance.
Presently, the domestic interest regime has completely     Fourth, interest rates can be used as monetary policy
liberalized. The evolution of the interest rate regime     targets. Many central banks, in recent years, have
from an administered one to one of full liberalization     moved towards interest rate targeting from
has been via a gradual process, with the interest rate     monetary targeting. Fifth, interest rate data can be
policy having been the most intensively used monetary      used to analyse exchange rate movements. The last
policy instrument in Nepal. It was made use of             but not the least, the interest rate data can be used to
achieving a number of objectives ranging from:             macroeconomic analysis of consumption, saving and
achieving stability in balance of payments (BOP);          investment. In this context, it must be noted that
accelerating resources mobilization; combating             interest rates play a key role in monetary analysis, as
inflation; deploying resources to the preferred sectors    they are a key element in the transmission process of
of the economy to enhancing competition in the             monetary policy.
financial sector and increasing efficiency of resource         The impact of interest rates on consumption,
allocation.                                                savings and investment is well established in the
    Before we discuss the evolution of interest rate       literature. Interest rates influence the growth process
policy in Nepal, it is important that we highlight the     by affecting the components of aggregate demand
analytical use and policy implication of interest rates.   and savings. Classical and Neoclassical economists
Interest rates are indeed very important economic          took a position that higher interest rates resulted in
variables. There are many uses of interest rate data.      high savings and lower level of consumption. Keynes,
418    NEPAL RASTRA BANK IN FIFTY YEARS

on the other hand, argued that low interest rates          legal measures were introduced to increase the
increased investment and income, and thereby               circulation of NC in place of IC, which was in
generating higher savings. Keynes put forward his          circulation along with NC. These two measures alone
ideas on interest rates in his seminal book, General       were not sufficient enough to help secure the full
Theory of Employment, Interest and Money in 1936.          circulation of NC throughout the Kingdom of
He strongly established a negative relationship            Nepal. IC continued to co-circulate. People in general
between the level of investment and interest rate. In      and business people and industrialists in particular
order to boost investment, he suggested a lower            continued to hold IC to store their wealth. As the
nominal interest rate. He argued that given marginal       people had stronger faith in IC than NC, this trust
efficiency of investment, a lower interest rate would      needed to be broken. Therefore, to break the faith
encourage investment, which, in turn, would increase       of the general public in IC, NRB used the exchange
output. This phenomenon, in economic literature, is        rate as an instrument. In May 1966, NC was revalued
known as Keynes effect. In case, nominal interest          by 57 percent to Rs 101 from Rs 160 per 100 IC.
rate could not be lowered, he sug gested for               Those who held IC for storing their wealth incurred
expansion in money supply, leading to a rise in            significant losses. This was a big blow to those who
inflation. A rise in inflation would lower real interest   held IC. This destroyed the faith in IC and thus helped
rate. This, in turn, would boost investment.               the full circulation of NC throughout the Kingdom
    Following Keynes, Tobin also developed a model         of Nepal.
of money and economic growth. Tobin argued that                This achievement, of course, has entailed
households would maintain their portfolio between          economic cost. The revaluation of NC against IC
money and productive capital assets. He argued that        made the Nepalese exports less competitive and
if the return on capital were to exceed the return on      made imports from India cheaper. This created a
money, the demand for capital in relation to money         serious BOP problem with India. For example, BOP
would increase, resulting in an increased capital to       deficit with India stood at Rs 126.1 million in 1965/
labor ratio. This would enhance labor productivity.        66 and Rs 22.0 million in 1966/67 (NRB, 1981). In
With increased labor productivity, per capita income       order to solve this problem, NRB, for the first time,
would go up. This analysis suggests for keeping            introduced a host of monetary policy instruments
nominal interest rates lower. In case, nominal interest    such as cash reserve ratio (CRR), margin requirement,
rates could not be maintained at low level                 refinance rate, statutory liquidity ratio (SLR) etc.
administratively, a case was made for an expansion         Interest rate policy was one of those policy
in the money supply. This would generate inflation,        instruments. In the light of a deficit in the BOP, NRB
driving down real interest rates. Against this             revised the prevailing deposit interest rate structure
theoretical background, most of developing countries       of commercial banks for the first time in 1966.
had controlled interest rate policy in 1960s, 1970s        Savings deposit rate was increased to a minimum of
and even 1980s (Fry, 1988).                                4 percent from 3 percent. One-year deposit rate was
                                                           increased from 4 percent to 6 percent. Interest rates
Administered Interest Rate Policy Regime
                                                           were fixed on an ad hoc basis. However, commercial
    When NRB began controlling interest rates in
                                                           banks were given freedom to offer higher than the
1966, the above were not the apparent considerations.
                                                           minimum interest rates fixed by NRB. Clearly, NRB
The context of introduction of controlled interest
                                                           began administering interest rates on deposits by
rate regime, therefore, requires the discussion on the
                                                           fixing the floor (the lower limit) of interest rate. As
historical circumstances, which compelled NRB to
                                                           regards lending rates, commercial banks could fix
administer interest rates. NRB came into existence
in 1956. But it did not use any monetary policy            themselves with the prior approval of NRB. Any
instruments during its first decade of existence.          way, interest rate policy was used to correct the BOP
Managing note issuance, ensuring the circulation of        deficit and also to influence lending rates so as to
Nepalese currency (NC) throughout the Kingdom              control domestic credit. To correct the BOP deficit,
of Nepal and achieving the exchange rate stability         it was important to attract the capital which had
of NC with Indian currency (IC) were the important         leaked out to India and deter further capital flight to
areas on which NRB was focusing. Institutional and         India. Deposit rates were also used to influence
                                                                                               INTEREST RATE      419

lending rates with the aim of contracting domestic          rural development. Under this programme,
credit, which was aimed at improving the BOP                commercial banks were directed to extend loans at
position of the country. Clearly, the BOP stability         a minimum 10 percent of their deposit to the priority
was the major motive when interest rate policy was          sectors. In 1984/85, commercial banks were directed
introduced for the first time. NRB succeeded in             to provide a minimum 25 percent, including 8
achieving a surplus in BOP with India in 1967/68.           percent to the priority sectors of their total loans to
    Although NRB began to control deposit interest          the productive sectors. The proportion of
rates in 1966, lending interest rates were untouched.       productive sector was raised to 40 percent, which
With an objective of reviewing the existing interest        included a minimum 12 percent to the priority sectors
rate structure of the commercial banks and term             in 1990. In the context of recent liberal interest rate
lending institutions, NRB constituted a high level of       policy, NRB decided to gradually phase-out the
committee under the chairmanship of a Deputy                priority sector-lending programme in 2002/03. For
Governor of NRB in 1969. The committee consisted            the current fiscal year 2004/05, the priority sector-
of representatives of the organizations of commerce         lending ratio stands at 4 percent. In subsequent two
and industries. The committee submitted its report          years, it will be 2 percent and it will not be
in August 1970. On the basis of report, NRB                 compulsory after 2006/07.
established a new interest rate structure effective April       In early 1970s, the general level of prices began
14, 1974. Deposit rates were increased to 5-8.5             to rise in the wake of oil price shock. For example,
percent from 4.5-7 percent and lending rates were           in 1972/73, inflation increased by 11 percent,
increased to 7.5-13 percent from 7-12 percent. With         followed by 18.8 percent in 1973/74 and 16.5
this, NRB began to administer both deposit rates            percent in 1974/75. The bank credit to the private
and lending rates.                                          sector was also accelerating. The rate of growth of
    After successfully overcoming the BOP problem,          time deposit was decelerating. In this context, interest
interest rate policy was used to accelerate the rate of     rate policy was used to contain inflation. With effect
domestic saving mobilization and help divert bank           from July 16, 1974, average savings rate was increased
credit to the productive sectors of the economy. To         from 5.0 percent to 6.5 percent and one-year deposit
achieve these twin objectives of increasing domestic        rate from 7.5 percent to 9.5 percent. Lending rates
savings and diverting bank resources to the preferred       were increased to 8-15 percent from 6.5-13 percent.
sectors, NRB adopted two approaches to interest             Interest rates were directed at increasing saving,
rate policy. First, it began to effect changes in the       thereby helping reduce consumption expenditure,
level of interest rate from time to time so as to           one of the components of aggregate demand.
influence domestic saving mobilization. Second, NRB         Interest rates were also increased to discourage at
commenced the differential interest rate policy for         least low yielding private sector investment, another
different types of bank credit, discriminating one type     component of aggregate demand. Among other
against the other. In order to extend the flow of           factors, an increase in interest rates did help contain
bank credit to the preferred sectors of the economy,        inflation. For example, the general price level declined
lower rates of lending were fixed and in order to           by 0.6 percent in 1975/76.
discourage the bank credit to some other sectors,               In the face of a rapid rise in general level of prices
higher rates of lending were fixed. In this context, to     in early 1970s, with given nominal interest rates, real
achieve the goal of diverting the bank credit to the        interest rates were falling. For example, one year real
productive sector, besides adopting the differential        deposit rate was negative 3.5 percent in 1972/73 and
interest rate policy, NRB also directed commercial          declined further to negative 9.3 percent in 1973/74.
banks to extend loans to the agricultural and small         Therefore, besides containing inflation, another
sector a minimum of 5 percent of their total deposit        objective of interest rate policy was also to keep real
in 1974. Such directed loans were renamed as priority       interest rates positive. In the process, big changes in
sector loans in 1976 and the proportion of such loans       interest rates were undertaken in the middle of 1970s.
was raised to 7.0 percent. To support the differential      Deposit rates were hiked as high as 16 percent and
interest rate policy, NRB introduced an intensive           lending rates were as high as 18 percent in 1975. With
banking programme in 1981. This was meant for               the hike of nominal interest rate, one year real deposit
420    NEPAL RASTRA BANK IN FIFTY YEARS

rate improved but still remained negative at 1.5           venture with United Emirates was established on July
percent. Real deposit rates turned positive only after     12, 1984. Nepal Indosuez Bank in collaboration with
1975/76 when the general price level declined. The         Indo-Suez Bank of France and Nepal Grindlays Bank
objective of increasing deposit rates was to attract       in collaboration with Grindlays Bank of UK were
savings into the banking sector and make deposit           established in 1986 and 1987 respectively.
rate structure in Nepal competitive with that of India.        The BOP deficit induced economic crisis proved
During this period, the credit of the banking sector       to be a turning point in the annals of economic policy
was expanding. Interest rates were also used to control    of Nepal. Nepal, as stated before, began to move
credit of the banking sector. To control credit, credit    gradually away from closed economic policies to
ceilings were also imposed since 1974. With the            open economic policies, signifying a shift in economic
substantial hike in interest rates, the growth of bank     policy regime. Along with the shift in policy regime,
credit decelerated. Time deposits with the commercial      financial sector reforms were initiated. Partial
banks increased by 35.9 percent, 30.1 percent and          deregulation of interest rates was one of the
19.2 percent in 1975/76, 1976/77 and 1977/78               components of the financial sector reforms initiated
respectively. The general price level declined and BOP     in early 1980s. Thus, the era of interest rate
improved. In the context of increased financial            liberalization began with the partial deregulation of
resources relative to bank credit, time deposit rates      interest rates announced in 1984. Under it, commercial
were lowered by one percentage point to 14-15              banks were given an autonomy to fix interest rates
percent with effect from July 1976. Interest rates were    over and above the interest rate fixed by NRB by
lowered further in March 1977. For example, one            1.5 percentage points higher in case of saving deposits
year and two-year deposit rates were lowered by            and 1.0 percentage point higher in case of fixed
one percentage point to 12 percent and 13 percent          deposits. It must be stated here that Nepal began to
respectively.                                              administer interest rates in 1966 when it faced the
                                                           BOP problem and began to liberalise interest rates,
Partial Deregulation of Interest Rates
                                                           albeit partially when it faced BOP problem again in
    In early 1980s, Nepal witnessed a critical BOP
                                                           early 1980s. In both the occasions, it began to
problem. There was a deficit in BOP for consecutive
                                                           administer interest rates with deposit rates and began
three years, 1982/83 through 1984/85. For example,
                                                           to liberalise interest rates with deposit rates.
the BOP deficit stood at Rs 675 million in 1982/83,
Rs 126 million in 1983/84 and Rs 866 million in            Objective of Partial Deregulation of Interest
1984/85. The persistent deficit in BOP led to the          Rates
depletion of international reserves. To overcome the           However, this time, the direct objective of the
critical BOP problem of that magnitude and                 change in interest rate policy was not overcoming
persistent nature, Nepal adopted economic                  the BOP problem. Nor was it directed at combating
stabilization programme in December 1985, which            inflation. The objective of partial deregulation of
was supported by an 18-month stand-by arrangement          interest rates was to create a competitive environment
with IMF. As a part of economic stabilization              in the banking industry. The goal of partial
programme, NC was devalued by 14.7 percent                 deregulation of interest rates was also to make it
against all major currencies; a tighter budgetary policy   consistent with the liberal domestic financial sector
was adopted; and bank credit to the government             policy. The objectives of interest rate deregulation
and government enterprises was reduced. After              were also to achieve (i) allocative efficiency, (ii)
successfully implementing stand-by arrangement,            operational efficiency and (iii) dynamic efficiency. It
Nepal decided to go for Structural Adjustment Facility     was thought that liberal interest rates rather than
(SAF) of IMF. Under the framework of SAF, a                controlled interest rates were the best way to achieve
number of reform measures were introduced.                 allocative efficiency of resources. Deregulation of
Among others, Nepal relaxed entry barrier in the           interest rates provides operational efficiency for banks
financial sector and thus opened the banking sector        and financial institutions. This is achieved through
for the private sector. Following this, three joint        improved competition in banks and financial
venture commercial banks were established in the           institutions. This helps lower financial intermediation
private sector. Nepal Arab Bank (NABIL), a joint           cost which would have a direct bearing on economic
                                                                                              INTEREST RATE     421

growth. Interest rate deregulation provides a sense         deregulation of interest rates on deposits and lending,
of freedom, which stimulates financial providers to         a number of policy changes in the financial sector
bring out various products benefiting both                  were initiated. To begin with, there was a shift
depositors and borrowers. This is the dynamic               towards, indirect monetary policy stance. There was
efficiency of interest rate deregulation. The partial       a gradual relaxation of direct monetary policy
deregulation of interest rates helped increase              instruments. Direct instruments such as credit ceilings
competition among banks and financial institutions.         and margin requirement were gradually removed.
Commercial banks actively competed among                    Directed credit progrmmes such as priority sector
themselves by increasing deposit rates. For example,        lending requirement is now being gradually phased
some commercial banks offered saving rates as high          out. There is now a greater reliance on open market
as 9.5 percent against 8.5 percent minimum rate fixed       operations as instruments of monetary policy. Along
by NRB. This had a positive impact on savings as            with this, a number of pr udential nor ms of
inflation rate was 4.0 percent.                             international standards are put in place.
    The interest rates were further liberalized with
                                                            Interest Rate Related Developments in the
effect from May 29, 1986. Banks and financial
institutions were permitted to provide any rates            Post 1989 period
higher than the minimum rates fixed by NRB.                     Some anomalies appeared after the complete
Likewise, lending rates were set free for all sectors       deregulation of deposit and lending interest rates.
except for the priority sector, which was not allowed       One such anomaly was that commercial banks started
to exceed 15 percent.                                       offering higher interest rates to some depositors and
                                                            lower to some other. Discrimination of depositors
Complete Liberalization of Deposit and                      in terms of interest rate differential without economic
Lending Rates                                               basis destroys the trust of the general public in the
    The work of McKinnon and Shaw in early 1970s            banking industry. This also puts small savers in a
provided the theoretical background of interest rate        disadvantageous position. Likewise, discrimination
deregulation in developing countries. McKinnon              of borrowers in terms of interest rate differential
(1973) and Shaw (1973) argued that controlled               for the same type of loans also creates distortions in
interest rates retarded economic growth. McKinnon           the banking industry. These practices needed to be
and Shaw contended that the deregulation of interest        checked. Hence, against the background of these
rates was important because it discouraged domestic         distortions and other developments, the following
investment in those areas, which were not yielding          regulatory and policy measures were introduced.
adequate rate of return in the long run. Ceteris paribus,       As a first measure, on August 22, 1993,
higher real interest rates increase domestic as well as     commercial banks were asked to fix interest rate for
foreign savings and total savings. It also increases the    at least one-year time deposit. No difference of more
flow of savings through financial intermediaries so         than one percentage point was allowed in the interest
that the overall efficiency of savings-investment           rate on credit to be provided for the same type and
process is enhanced. It is argued that liberalization       purposes. Banks were also prohibited to fix flat
of interest rate would reduce the monetisation of           interest rate.
budget deficit.                                                 The second measure was the fixation of interest
    In the light of above theoretical background,           rate spread. As it is obvious, one of the objectives
interest rates, both deposit rates and lending rates        of interest rate deregulation was to help lower the
have been completely liberalized since August 31,           financial intermediation cost in the form of interest
1989. The objective has been to create a more
                                                            rate spread i.e. the difference between deposit rate
competitive environment in the financial sector. In
                                                            and lending rate through competition. However, it
fact, there have been two objectives of a complete
                                                            was found that after the deregulation of interest rates,
deregulation of interest rates of banks and financial
institutions. The first is to encourage banks and           commercial banks lowered deposit rates and did not
financial institutions mobilize financial resources. The    lower lending rates to the extent at which they
second is to help banks and financial institutions          lowered deposit rates. Likewise, when they increased
allocate resources optimally. To support the complete       lending rates, did not increase deposit rates to the
422    NEPAL RASTRA BANK IN FIFTY YEARS

extent at which they increased lending rates. In both      of upper limit for interest rate spread at 6 percent
cases, the result was increased interest rate spread. At   was introduced since August 22, 1993. The spread,
the time of interest rate deregulation, it was hoped       as discussed above reflects the financial
that both depositors and borrowers would benefit,          intermediation cost and it is considered to be an
because commercial banks would compete among               important indicator of financial market. To put it
themselves through interest rates, offering higher         differently, the spread is the barometer showing the
deposit rates and charging lower lending rates. In the     level of efficiency of commercial banks. Needless
process, interest rate spread would come down. But         to say, the lower is the spread, the higher is the
this did not happen. On the contrary, interest rate        efficiency and the higher is the spread, the lower is
spread increased after the deregulation of interest        the efficiency of commercial banks. To begin with,
rates.                                                     moral suasion was used to limit the spread at 6
    Generally speaking, a high spread is indicative of     percent. The system of penalty was not introduced
inefficiency of commercial banks. This is true for         in the event of violation of interest rate spread. When
large domestic commercial banks. But this is not the       it was found that commercial banks did not pay
case of joint venture private commercial banks.            attention to NRB’s moral suasion, the matter was
Ironically, joint venture commercial banks maintained      taken up seriously. Hence, the interest rate spread
relatively higher spread. It appeared that there was       ceiling was reviewed and made stringent further by
no competition among the commercial banks. But             lowering it to 5 percent on July 16, 1998. The main
the fact was that Joint venture private commercial         objective of the imposition of stringent interest rate
banks instead of conducting their business                 spread was to increase financial intermediation by
competitively appeared to prefer benefiting from the       forcing commercial banks to lower their financial
inefficiency of large domestic banks. That is to say       intermediation cost.
that joint venture private banks benefited but the             NRB, in the mean time, adopted a number of
general people at large and the economy did not.           measures aimed at helping reduce the spread. CRR
There were a number of causes for higher spread            was one of the instruments that were used to help
for large domestic banks. Mounting non-performing          commercial banks lower their spread. As CRR acts
loans, overstaffing and a large number of                  as a tax on financial intermediation, the higher level
unproductive staff, collection and extension of small      of CRR increases the financial intermediation cost
amounts of loans, unviable branches in remote areas        implying a higher interest rate spread. In the light of
and priority sector lending were some of the factors       this fact, to begin with, the level of CRR was reduced
for higher spread for large domestic commercial            from 12 percent to 10 percent in 1998. It was further
banks with the government involment. These were            reduced to 9 percent in December 2001 and 8
not the issues for joint venture commercial banks. In      percent in 2002. CRR was cut further to 6.0 percent
a way, instead of competing among themselves for           in 2003. On July 19, 2004, CRR was reduced further
their business expansion through interest rate,            by one percentage point to 5.0 percent (Table 1).
commercial banks entered into a collusion. In this             Likewise, the bank rate was gradually lowered.
context, it was argued that private sector banks took      To begin with, the bank rate was reduced to 9 percent
advantage of the weaknesses of the two large               from 11 percent in 1997. The bank rate was further
domestic banks, namely, Nepal Bank Limited (NBL)           lowered to 7.5 percent on April 14, 2000, 6.5 percent
and Rastriya Banijya Bank (RBB). For example,              in July 2001 and 5.5 percent on December 20, 2002.
unweighted interest rate spread went up as high as 7       Likewise, between 1998 and 2005, other refinance
to 8 percent. Following the interest rate deregulation,
                                                           rates were also lowered from 7.0 percent to 1.5 -
this was considered to be very high compared to 2
                                                           3.25 percent. Besides this, with a view to help
to 3 percent spread in other countries. This was also
in contrary to what was expected following the             commercial banks increase their profitability by
financial sector reforms. High spread tends to reduce      parking their idle reser ves in the short-ter m
financial intermediation with obvious impact on            government securities, non-marketable government
economic growth.                                           securities held by NRB and the government overdraft
    The above was the background against which the         from NRB amounting to Rs 29 billion were
interest rate spread was imposed. The imposition           converted into marketable treasury bills between
                                                                                                  INTEREST RATE        423

March 9, 1999 and December 1, 2002 (Table 2). Such             calculated by multiplying interest rates with weights
treasury bills were sold to the commercial banks               with corresponding loans. However, the
through the secondary open market operations. These            methodology of weighted spread was the ex-post
monetary policy measures had intended effects on               rather than ex-ante as discussed above. While
the level and the structure of interest rates (Table 2).       calculating the weighted spread, the realized interest
    NRB announced the withdrawal of the interest               incomes on loans and investment and the actual
rate spread fixed at 5 percent with effect of July 16,         interest paid to the depositors were taken. As per
2002. There were many reasons for the withdrawal               this methodology, those commercial banks, which
of the spread. First, following the imposition of the          had problem loans and had difficulties in collecting
spread limit, criticisms began to pour in. It was argued       interest or loans, had lower level of spread. Therefore,
that the fixation of interest rate spread destroyed the        the actual spread did not reflect the true picture of
spirit of interest rate deregulation. The removal of           the efficiency of commercial banks. The fact also
interest rate spread was also in keeping with this             paved the way for the removal of interest rate spread
criticism. Second, almost all commercial banks had             (Table 3).
maintained the spread within the limit. In a way, it
                                                               Interest Rate Structure in Nepal
was also easy for the commercial banks to keep the
                                                                   There are different types of interest rates in Nepal.
spread within the limit. The 5 percent spread was
the weighted spread. Weighted deposit interest rates           Let us begin with the central bank interest rates.
were supposed to be calculated by multiplying interest         Among the central bank interest rates, the bank rate
rates with the weight of corresponding deposits.               is very important. The bank rate is interest rate
Likewise, lending rates were supposed to be                    charged by NRB whenever commercial banks
  Table 1
  CRR (in percent)
                                                1990        1998         2001         2002          2003        2004
  A     CRR with NRB                                8.0    Avg. 7.0    Avg. 6.0      Avg. 6.0       6.0         5.0
  1     Of demand deposit                            -        8            7            7            -            -
  2     Of saving deposit                            -        8            7            7            -            -
  3     Of fixed deposit                             -        6           4.5          4.5           -            -
  B     Vault CRR                                   4         3            3            -            -            -


 Table 2
 Bank and Refinance Rates
                                                            Refinance Rates (Percent)
                                     Foreigh Currency        Export Loans in Domestic
                      Bank Rate           Loans                 Currency and RDB                Sick Industry Loan
 1967                    6.0                   -                                                           -
 1975                    15.0                  -                           -                               -
 1989                    11.0                  -                           -                               -
 1991                    13.0                  -                           -                               -
 1997                    9.0                   -                           -                               -
 1998                    9.0                 5.5                          7.0                              -
 2000                    7.5                 5.5                          6.5                              -
 July 16, 2001           6.5                 4.0                          5.5                             4.5
 December 18, 2001       5.5                 2.0                          4.5                             3.0
 July 28 2003            5.5                 2.0                          4.5                             2.0
 July 19, 2004           5.5                 2.0                          3.0                             1.5
 May 31, 2005            5.5                 3.25                         3.0                             1.5
424      NEPAL RASTRA BANK IN FIFTY YEARS

 Table 3                                                       To begin with, the yield curve was the basis of
 Conversion of Overdraft and Special Bond                      determining interest rates for such operations. NRB
 into Treasury Bills                                           used to suck in liquidity from commercial banks if
 Rs. in million                                                they bid interest rate below the yield curve and used
                      Maturity       Interest                  to inject liquidity by adding some mark up to the
 Conversion Date       Period          Rate      Amount        yield curve rate.
 March 9, 1999         364 days         5.5       3980.4           With effect from March 25, 1997, NRB
 March 23, 1999        364 days         3.8       2224.0       introduced repo as a short-term instrument with the
 April 25,2000          91 days         2.7        930.0       maximum maturity period of seven days to inject
 Sep.26, 2000          364 days         4.0       3785.0       liquidity into the system. Repo rate was fixed by
 April 17, 2001         91 days         4.8        590.0
 October 2, 2001       364 days         5.0       5449.0
                                                               adding 0.5 percent to the market determined simple
 Sept. 5, 2001         364 days         5.0       6546.7       average of weighted average of 91-day treasury bills
 Dec. 1, 2002          364 days         4.7       5898.3       in the last four auctions.
 Total                                          29,403.4           Although, interest rates of secondary open market
                                                               operations were based on market interest rates, they
borrow from it as a last resort measure. Currently,            were not directly market determined when such
the bank rate is 5.5 percent. The current bank rate at         operations were conducted. Auction was not the basis
5.5 percent is in effect since December 2001. Prior            of such operations. Therefore, it was argued that
to this, the bank rate was 6.5 percent. The bank rate          interest rates on such operations were not transparent
is rather notional (benchmark) rate. The bank rate             to market participants. As against the background
has been used to indicate the stance of monetary               of this criticism and also with a view to make interest
policy. In recent times, commercial banks have not             rates of such operations market determined, NRB
borrowed from NRB at the bank rate. It has also                introduced a system of sale auction, purchase auction,
been de-emphasized in recent times. But it is still put        repo auction and reverse repo auction since July 19,
in place so that under extra ordinary circumstances,           2004. With this, now we have market determined
commercial banks can borrow. NRB makes                         interest rates for all open market operations.
refinancing to rural development banks and exporters               Open market operations discussed above take
for their export loans at local currency. The                  place with NRB’s initiative. The purpose of these
refinancing rate for these types of loans provided             operations is to achieve monetary policy objectives.
by NRB is currently 3.0 percent. NRB also makes                When these operations are not undertaken and
refinancing available in foreign currency for export           commercial banks require liquidity, standing liquidity
loans in foreign currency. Refinancing rate for this           facility (SLF) has been introduced to provide an
type of loans was 2 percent until May 31, 2005 when            automatic but fully collateralized liquidity facility for
it was raised to 3.25 percent. Refinancing rate for            commercial banks for a maximum period of 5 days.
sick industry loans is currently 1.5 percent.                  This is a safety valve for domestic payments system.
     Of the interest rates on government securities,           The SLF rate is based on the latest average 91- day
interest rates on treasury bills are market determined.        treasury bills rate. With a view to check the misuse
The system of auction for the primary issuance of              of this facility, a penal rate is added to the latest 91-
treasury bills began since November 25, 1988. Ever             day treasury bills rate. Currently, the penal rate is 2
since Treasury bill rates are market determined.               percent. When the bank rate is completely de-
Currently, 28-day, 91-day, 180-day and 364-day                 emphasized and in case abolished, the penal part of
treasury bills are issued and all of them are issued on        SLF rate is likely to be the monetary policy rate. This
the basis of auction. The wide spectrum of Treasury            rate will act as a signaling rate of monetary policy
bill rates gives us the benchmark yield curve especially       stance.
for commercial banks. The interest rates on these                  Besides treasury bills, the government borrows
securities are reflective of market liquidity conditions.      from the market by issuing development bonds,
     With effect from June 16, 1994, NRB began to              national saving certificates and citizen saving
operate secondary open market operations (OMOs).               certificates. While development bonds are basically
Under it, NRB started to sell government securities            meant for banks and financial institutions, national
to suck in liquidity and buy securities to inject liquidity.   savings certificates and citizen savings certificates are
                                                                                                 INTEREST RATE     425

for households. Since June 2, 2005, the system of             judging the optimum level of domestic interest rate.
auction has been introduced for the primary issuance          It is important to attract foreign capital. In this case,
of development bonds. Development bonds issued                it must be higher than international interest rates. In
on June 2, 2005 and June 9, 2005 carried a coupon             Nepal’s case, Indian interest rates could be reference
rate of 5.5 percent. They were sold on premium.               rates. Third, returns on investment projects are also
These development bonds listed in Nepal Stock                 important factors to judge the appropriate levels of
Exchange for the secondary transactions. The                  interest rates. Fourth, in a developing country like
objective of this new system is to find out the market        Nepal, interest rates in unorganized markets can be
interest rates for these bonds. The idea is to take these     also used to judge the appropriate level of interest
interest rates into consideration while fixing coupons        rate.
fresh development bonds. However, interest rates,                 There are various theories, which explain the
on national savings certificates and citizen saving are       determination of interest rates. Classical theory posits
fixed administratively. Hence, these debt instruments         that interest rate is a real phenomenon and hence real
carry coupons, implying fixed interest rates. For the         factors determine the level of interest rate. The real
time being, no auction for secondary transactions of          factors are the supply and demand for capital. It is
national savings certificates and citizen savings             argued that the supply of capital comes from savings
certificates is planned. Therefore, national savings          (thrifts) and the demand for capital comes from the
certificates and citizen savings certificates will continue   productivity of capital. Interaction of supply of and
to carry coupon rates without market determined               demand for capital gives us the equilibrium level of
proxy interest rates.                                         interest rate. Therefore, if there is recession in the
                                                              economy, the return from investment will be low.
Interest Rate Determination                                   This will bring down the overall demand for capital.
     Whether market determined or determined                  Given the level of savings (the supply of capital), the
administratively, there are two aspects of interest           lower level of demand for capital will bring down
rates. The first aspect is the level of interest rate and     the level of interest rates. Thus, according to the
the second aspect relates to the structure of interest        classical economists, interest rate is a real
rates. In an interest rate deregulated economy, market        phenomenon.
forces determine the level and the structure of interest          The Neoclassical theory is based on loanable
rates. With respect to the former, one of the questions       theory of interest rate. The loanable theory includes
that is very often asked is about the appropriate level       both real and monetary factors. This is an
of interest rate. For that matter, one can ask: what is       acknowledgment of the fact that monetary factors
an optimal rate of interest for an economy? Whether           also influence the level of interest rates. According
interest rates are market determined or administered,         to Keynes liquidity preference theory, interest rates
it is difficult to get a right answer to the question of      are purely monetary phenomena. Demand for and
the optimal level of interest rate. Nonetheless, there        supply of money determine the level of interest rate.
could be a number of ways of judging the                      Thus, according to Keynes, monetary policy, for that
appropriate level of interest rate. First, one such way       matter, money supply can be used to influence the
is the real rate of interest. It should be positive. A        level of interest rate in the economy.
positive real interest rates encourages savings. It               On the basis of these theories, a number of
discourages low yielding investment and thus has              factors, which influence the level of interest rate, can
positive impact on growth. Again the question                 be discussed. Among the factors influencing the level
remains unanswered. The question that again can be            of interest rates, the size of government borrowing
asked is as to what should be the optimum level of            is very important. The higher the size of the budget
real interest rate. If some inferences can be drawn           deficit, the higher is the level of interest rate and the
from the Taylor’s monetary policy decision rule, the          lower is the size of the budget, the lower is the level
level of real deposit rate should be 2.0 percent. Once        of interest rate. This fact has been one of the factors
we agree to this and add the inflation rate to the 2.0        affecting the level of interest rate in Nepal. It is to be
percent desired real interest rate, optimal nominal           noted that both the government and the private sector
interest rate can easily be calculated. Second, interest      borrow from the domestic market. Obviously, funds
rates abroad should be also taken into account while          that can be borrowed from the domestic financial
426    NEPAL RASTRA BANK IN FIFTY YEARS

market are given. With the given funds in the               the conflicting relationship between money supply
domestic financial market, when the government              and the level of interest rates, it is important to know
domestic borrowing increases, it puts pressure on           the process through which the changes in money
domestic interest rates. In the process, interest rates     supply are transmitted into interest rate changes. The
rise to clear markets. With the rise in domestic interest   economic literature discusses four effects in this
rates, the government borrowing crowds out the              regard. These are income effect, price level effect,
private sector investment. In the past, the government      expected inflation effect and liquidity effect. It is
used to resort to relatively a large budget deficit.        argued that an increase in money supply leads to an
Some portion of budget deficit used to be domestic          increase in investment, which increases income of
financed. The government borrowing from the                 the people. A rise in income increases demand for
domestic market on a large scale used to drive up           money. Given the supply of money, an increase in
market interest rates. Recently, the government             money demand drives up interest rate. It is also
domestic borrowing has decelerated. So have the             argued that a rise in money supply causes the overall
market interest rates. In some cases, public debt           price level to go up. In response to a rise in the price
management policy also influences the level of interest     level, nominal interest rates also go up. Likewise, it is
rate. Some times, a lower level of interest rate policy     contended that an increase in money supply leads
is adopted to reduce the cost of borrowing for the          people to expect a higher price level in the future,
government. It can also be used to discourage               leading to a higher inflation expectation This also
government from borrowing.                                  causes nominal interest rates to go up.
     The second factor relates to business conditions.          The other view is that an increase in money supply
When economic recovery takes place, economic                causes liquidity to go up. An increase in liquidity in
activities increases. In the process, the demand for        turn drives down the interest rates. Of the four effects
funds increases, putting an upward pressure on              of money supply such as income effect, price level
interest rates. On the other hand, when the economic        effect, expected inflation effect and liquidity effect,
is in recession, the demand for funds declines, leading     the first three indicate a rise in interest rates and the
to fall in interest rates. Currently, the economic          last one indicate a fall in interest rates when money
activities are at a low level in Nepal. This explains the   supply increases. It is also to be noted that while the
current low level of interest rates in Nepal.               first three take time to generate effects, the last one
     The third factor relates to the role of lobbies and    generates the immediate effect. The trend of interest
pressure groups. In the society, the different interest     rates over the last few years is any guide; money supply
groups play their roles in raising or lowering interest     relative to money demand to some extent has
rates. Retirees will like to see deposit rates going up.    contributed to the fall in interest rates. However, it is
Likewise, households will also prefer higher interest       difficult to tell which effect is dominant in Nepal by
rate on their deposits. On the other hand, industrialists   looking at data. Only empirical test will settle the issue.
and business community will put pressure for lower          Therefore, in order to make an empirical study of
interest rates. Thus, lobbies and absence of lobbies        money supply-interest rate relationship, the quarterly
from business community, industrialists and                 polynomial distributed model is estimated. The
households also influence the level of and structure        sample period is between the third quarter of 1993
of the interest rates. In the Nepalese context,             and the fourth quarter of 2004. Owing to lack of
industrialists and business have been found exerting        quarterly data on interest rate, the sample period
pressure on monetary authorities and the political          could not be expanded before 1994. One-year
authorities for a lower level of interest rate.             average deposit rate and industrial average lending
                                                            rate are regressed on money supply (M1). The
Relationship between Money Supply and
                                                            polynomial distributed lag model has been used to
Interest Rates                                              see both the size and speed of adjustment of interest
    In the light of above discussion, it is important       rates with the changes in money supply.
to understand the relationship between money supply             The polynomial distribution lag model showing
and interest rates. There is one school of thought,         the pass-through effect of money supply to deposit
which establishes a negative relationship whereas the       rate (one year) reveals that money supply has impact
other establishes a positive relationship. To understand    on deposit rate. The regression result shows that
                                                                                           INTEREST RATE     427

the immediate impact of 10 percent increase in               The regression results shown in Table 4 and 5
money supply is 5.0 percent decline in on one-year       show that the response of deposit rate to changes in
nominal deposit rate. The polynomial distributed         money supply is larger than the response of lending
model shows that money supply changes have               rate to changes in money supply. This means
impact on deposit rate distributed over three            commercial banks adjust deposit rate quicker and in
quarters. The sum total impact of 1 percent change       larger proportion in response to changes in money
in money supply distributed over three quarters is       supply relative to lending rates.
1.31 percent on deposit rate (Table 4). The
regression result shows that the pass-through impact     Interest Rate Pass-through
of money supply on deposit rate is greater than unity.       As interest rates are deregulated since 1989, NRB
    Likewise, a polynomial distributed lag model of      cannot determine market interest rate directly.
industrial average lending rate as dependent variable    However, monetary policy measures have been used
and money supply as independent variable has been        to influence market interest rates indirectly. A number
estimated. Unlike the deposit rate, immediate impact     of monetary policy measure have been used to
of money supply on lending rate does not exist. In       influence interest rates. Of the monetary policy
fact, the coefficient of lending rate regressed on       measures, the bank rate and refinance rates have been
contemporaneous money supply does not have a             actively used to influence the market interest rates
priori sign. The sum total effect of money supply        especially in recent years. For example, the bank rate
spreading over three quarters is a negative of 0.49.     has been changed in seven times during the post interest
This indicates that one unit change in money supply      rate liberalization period. It was 11 percent in 1989
drives down lending rate by 0.49 over the period of      and increased to 13 percent in 1991. The bank rate
three periods (Table 5).                                 was gradually lowered to 5.5 percent in 2001 (Table
                                                         2). Keynes, contrary to old quantity theory, established
 Table 4                                                 the relationship, albeit indirect, between money supply
 One-Year Average Deposit Rate Regressed                 and real output. The missing links between money
 on M1                                                   supply (or monetary policy ) and real output are interest
 Lag distribution of                                     rates and investment. The first step in the Keynesian
 log (M1)               Coefficients    t-statistics     transmission of monetary policy is the relationship
 0                          -0.50          -2.34         between money supply relative to money demand and
 1                          -0.48          -3.45         interest rate. Obviously, the Keynesian relationship
 2                          -0.32          -2.17         between money supply and the rate of interest is
 3                          -0.01          -0.06         negative. It refers to that an increase in money supply,
 Sum of lags                -1.31          -3.63         other things remaining the same, reduces interest rates.
                                                         However, this is the ex-post analysis of monetary
 Adjusted R2 = 0.98
                                                         policy. The ex-ante monetary policy stance can be
 DW Statistics = 2.14
                                                         depicted in the form of the bank rate. For example,
                                                         the lower level of bank rate reveals the accommodative
 Table 5
                                                         monetary policy ex-ante. The higher bank rate will
 Industrial Average Lending Rate Regressed
                                                         reveal the tight monetary policy ex-ante. The interest
 on M1
                                                         rate pass-through effect in the Keynesian framework
 Lag distribution of                                     is anlysed in terms of the impact of changes in the
 log (M1)                Coefficients    t-statistics    bank rate on deposit rates and lending rates.
 0                           0.12           0.76             Testing the model as discussed above, the
 1                           -0.26          -2.98        immediate pass-through effect of the bank rate to
 2                           -0.32          -3.13        one-year deposit rate is 0.05. This means that one
 3                           -0.04          -0.28        unit change in the bank rate brings about 0.05 changes
 Sum of lags                 -0.49          -6.44        in one-year deposit rate immediately. The polynomial
                                                         distributed model applied shows that the sum total
 Adjusted R2 = 0.96
                                                         impact of bank rate on one-year average deposit
 DW Statistics = 2.41
                                                         rate is 0.30 (Table 6).
428    NEPAL RASTRA BANK IN FIFTY YEARS

    In the case of lending rate, the pass-through effect   monetar y policy. Under the circumstances,
is higher than that of deposit rate. The sum total of      depending upon the macroeconomic situation and
pass-through effect of bank rate to lending rate is        evolving monetary conditions, basically quantities
0.64, implying one unit increase in bank rate drives       rather than prices are used to influence the market
up the lending rate by 0.64 unit. However, the model       and thereby to achieve the objective of monetary
is not robust in terms of t-statistics, adjusted R2 and    policy.
Durbin-Watson statistics. It is not clear from the             The economy is not doing well at the present
model whether the response will prevail in case of         juncture. The financial health of some dominant banks
cut in the bank rate or not (Table 7).                     and financial institutions still remains fragile. Although
                                                           the current account has been opened, the capital
 Table 6                                                   account is yet to be fully opened. Upon the
 Pass-through effect of Bank Rate to One                   consolidation of the financial sector stability and
 Year Average Deposit Rate                                 opening up the capital account, it will not be necessary
 Lag distribution of                                       and sustainable either to continue the pegged
 log (M1)                 Coefficients   t-statistics      exchange rate regime. In that eventuality, Nepal will
 0                            0.05           0.42
                                                           have to look for an alternative framework for
 1                            0.07           083           monetary policy. Nepal will have to choose one from
 2                            0.09           097           remaining three options. Formal targeting of
 3                            0.09           0.88          monetary policy is one option. But this framework
                                                           to be viable requires the stable money demand
 Sum of lags                  0.30           1.19
                                                           function. As Nepal is undergoing the process of
 Adjusted R2 = 0.03                                        financial sector reforms and institutional restructuring,
 DW Statistics = 1.51                                      stability in money demand function will be untenable.
                                                           Under such circumstances, monetary targeting will
  Table 7                                                  not be favored. Then two options for monetary
  Pass-through effect of Bank Rate to                      policy framework are left: inflation targeting and
  Industrial Average Lending Rate                          interest rate targeting. Inflation targeting is more of
                                                           institutional arrangement involving the setting up of
  Lag distribution of                                      goal function through the political process, setting
  log (M1)               Coefficients    t-statistics      up of monetary policy reaction function (policy
  0                          0.20           1.39           decision rule), and estimating core inflation,
  1                          0.05           0.47           transparency, credibility and instrument independence
  2                          0.08           0.75           of central bank. Moreover, the role of Indian prices
  3                          0.30            2.4           in influencing the Nepalese prices cannot be ignored.
  Sum of lags                0.64           2.05           In case, available resources did not allow us to go
                                                           for inflation targeting, Nepal will be left with only
  Adjusted R2 = 0.09
  DW Statistics = 2.5                                      one option of interest rate targeting. Even if we were
                                                           to adopt inflation targeting or flexible exchange rate
                                                           targeting, interest rate will be operating target.
Future Agenda on Interest Rate Policy                      Therefore, the future agenda for Nepal is to prepare
    The above discussion shows that almost all interest    groundwork either for full-fledged interest rate
rates except for coupon rates for national saving          targeting or interest rate as operating target of
certificates and citizen saving certificates are market    monetary policy.
determined. So far, the objective of complete              References
deregulation of interest rates has been to leave market
                                                           Fry, M. J. (1988), “Money, Interest and Banking in
forces free to determine the optimum level of interest        Economic Development,” The Johns Hopkins
rates for the economy. The fixed exchange rate                University Press, Baltimore and London.
regime with the Indian Currency but floating with          NRB (1981), “25 Years of Nepal Rastra Bank, NRB,
other currencies, serves as the nominal anchor of             Kathmandu, Nepal.
                                                                        INTERNATIONAL TRADE AND PAYMENTS       429




                     International Trade and Payments
                                                Shiba Devi Kafle
                                         Act. Director, Research Department
Introduction                                                           financial support from many countries
   Because of the rapid economic and                                   and donor agencies. In this regard,
technological development, no country                                  international transactions activities are
can remain isolated from others. All                                   becoming very crucial.
countries are directly or indirectly                                          This paper first discusses the
dependent on each other. Even the                                      theoretical aspects of international trade
communist countries, which earlier used                                briefly. Next, the external sector policies
to be isolated from the rest of the world,                             as well as trade pattern of Nepal are
are now almost open for trade and other                                summarized from the historical
economic activities. Highly developed                                  perspective. A review of the balance of
countries rely heavily on the markets of the                 payments statistics is also undertaken. Before
developing countries. Likewise, developing countries         concluding the paper with some concrete suggestions,
have to import development materials and                     major problems are also identified.
manufactured products from developed as well as              Theoretical Aspects of International Trade
developing countries, and have to export their
                                                             Concept of International Trade
primary and manufactured goods on the production
                                                                 The concept of international trade deals mainly
of which they have comparative advantage. In order
to raise employment, income and thereby living               with transactions of goods and services among the
standard of people, economic activities need to be           residents of different nations of the world. The field
expanded. For this, in the inadequacy of domestic            has grown wider as international trade activities also
capital, efficiency, and willingness, foreign capital and    include financital flows and the movements of factors
technology can be very useful in two ways: to acquire        of production, such as labour, capital and
goods and services from abroad in reasonable value,          entrepreneurship along with the transactions of
and to utilize abundant domestic resources and               goods and services. Therefore, international trade can
enhance production for internal and international            be defined as “the business activities” of exchanging
consumption. Therefore, in today’s world, external           goods and services among residents of different
sector performance has been growing rapidly.                 countries. In general, a country forwards its goods
Nepal’s external sector activities are also growing          and services to the rest of the world, in which it is
significantly. Its trade relation with India and Tibet is    efficient in production. Similarly, goods and services
very old. Now, Nepal has such relations with more            that can be acquired at lower prices abroad than at
than one hundred countries. Similarly it has acquired        home is imported from the rest of the world. In
430    NEPAL RASTRA BANK IN FIFTY YEARS

this way, the fundamental basis of foreign trade lies         production, employment, and income. And thus,
in the fact that all countries are not equally efficient in   demand for goods and services increases, motivating
the production of all things they need. This is because       the expansion of production activities and trade.
of the unequal distribution of natural resources,             Likewise, improved performance can be stimulated
different geographical situation, less substitutability       by competition from imports. This is because, as
of factors of production among countries, different           mentioned earlier, import competition helps in
level of development and so on. International trade           removing inefficient domestic firms and drives others
is considered as the important medium of raising              to higher performance standards. Trade checks the
people’s living standards and the prosperity of               power of local monopolies to exploit their domestic
economies. Therefore, it is said that a great deal of         markets through high prices. Thus, free and fair trade
economic well being of most nations rests on                  favours the consumers by providing standardized
international interdependence. The larger volume of           goods and services in competitive prices.
world trade than that of the world output justifies               However, international trade in unlimited manner
that such interdependence among countries is                  may not be desirable in all the circumstances.
growing extensively.                                          Therefore, the objective of trade policy should be
                                                              of a balancing type. Trade should not deprive any
Importance of International Trade
                                                              nation of the benefits from learning to produce
    International trade plays a very important role for
                                                              goods and services that could be imported. Trade
all countries. It provides a very good market for the
                                                              should not hamper the growth process; rather it
manufactured and other commodities. In the system
                                                              should be adapted as a medium to fulfill the
of international trade, a country can specialize in those
                                                              requirements of growth and development. Export
products in which they have comparative advantage
                                                              augmentation is an important element of growth and
and can export them in the international markets after
                                                              development. A substantial expansion of exports is
fulfilling the domestic needs of those goods. Similarly,
                                                              very imperative for sustained economic growth.
it can import those goods and services, which are
                                                              Exports are also required to compensate for the
relatively more expensive and difficult to produce
                                                              imports of necessities and goods for productive
within the country. In other words, the country
                                                              purposes to capture the benefits of specialization.
specializes in the production of only a small number
                                                                  By participating in the international capital markets,
of goods in which a great comparative advantage
                                                              countries can grow faster. By borrowing from those
can be achieved. Similarly, benefits from trade are
                                                              markets, countries can supplement domestic savings
also acquired on economies of scale. A country can
                                                              and raise their rates of capital formation. From the
gain considerably by importing goods that can be
                                                              point of view of capital providers, by lending on
produced cheaply on a large scale in foreign countries.
                                                              those markets, countries can put their savings in more
The central idea of international trade is to provide
                                                              productive place. International trade in claims and
an array of benefits to a country through the provision
                                                              liabilities raises the efficiency of an economy.
of material means, e.g., capital goods, machineries
                                                                  Improvement in technology developed in one
and raw materials. International trade is a medium
                                                              country is shared automatically with other countries.
for the transmission of technological knowledge.
Likewise, it is considered as a vehicle for the               They are shared directly when they are embodied in
international movement of capital from developed              new capital equipment that is sold on world markets.
countries to less developed countries. Similarly, free        They are shared indirectly when they raise efficiency
trade fosters healthy competition and brings efficiency       or product quality in the export industries of the
in the industrial sectors wiping out all inefficient          country in which they originate.
industries.                                                       The importance of international trade can be
    In a free trade system, a country’s products have         summarized as:
access to the international market. Because of this,              It fulfils the necessities of material means, i.e.,
domestic production activities can be enhanced based              capital goods, machineries, and raw materials
on the endowment of resources. Such enhancements                  for industrial activities.
promote incomes, thereby demand. It is very obvious               It is the useful instrument for the transmission of
that the size of the market limits the extent of the              the technological knowledge.
                                                                         INTERNATIONAL TRADE AND PAYMENTS          431

    It acts as the vehicle for the international             obvious in large economies and reverse is the case
    movement of capital from developed countries             for small economies.
    to less developed countries.
                                                             Growth of International Trade
    It fosters healthy competition and keeps in check
                                                                 It is difficult to say when the idea of trade actually
    inefficient industries.
                                                             developed. The development of trade has been
    It enables a country to specialize based on its
                                                             expanding with greater choice of goods among
    abundant resources.
                                                             people in different countries. Development in
    It provides consumers a better access for
                                                             technology and transportation are other responsible
    commodities.
                                                             factors for the expansion of international trade. It is
    There are some arguments about international
                                                             said that the history of international trade is as old as
trade and finance as they raise economic problems
                                                             human civilization. However, the growth of
by affecting the international behavior of each
                                                             international trade can be reviewed as below:
national economy. They raise political problems by
                                                             • “Archaeological discoveries show the evidence of
affecting relations among governments. Likewise,
                                                                 trade practices even prior to recorded history. The
events in the international markets can affect levels
                                                                 significance and the scope of trade were already
of domestic employment and inflations rates. The
                                                                 well identified by the Egyptians, Greeks, Romans
unprecedented increase in the world price of oil that
                                                                 and Phoenicians thousands of year ago” (Shakya,
began in 1973 was the major cause of stagflation
                                                                 1991). At that time, goods traded were, of couse,
(the painful combination of high unemployment,
                                                                 in small number and consisted of agricultural and
slow growth and rapid inflation) in oil importing
                                                                 primary products.
countries. Changes in the price of raw materials affect
                                                             • Mercantilism, the economic philosophy of
the export earnings of developing countries by raising
                                                                 merchants during the 16th and 17th centuries
the cost of production and then reducing
                                                                 remained till the late 18th century. The basic
competitiveness. Export earnings determine the
                                                                 doctrine of mercantilism was to accumulate
ability to import machineries and other capital goods.
                                                                 wealth (gold and silver) at the expense of other
In this way, such price movements in the international
                                                                 countries. In other words, the theme of this
markets influence the pace of development.
                                                                 philosophy was extreme export promotion and
The Growth of Economic Interdependence                           discouragement of import. This philosophy
    The rapid growth of international transactions               developed the ideas of protectionism and it
has strong links between economies. An increase in               introduced arrays of trade barriers. However, the
one country’s income will raise its demand for                   industrial revolution replaced the doctrine of
imports. And the imports of one country are exports              mercantilism. The classical thought of laissez-faire
of other. Therefore, the increase in one country’s               policy overtook mercantilist philosophy.
income will raise the other countries’ exports and           • Because of the industrial revolution of mid-
thus raise their incomes. Similarly, an increase in one          eighteenth century, which developed new
country’s interest rates will attract capital from other         technologies in European industries, the
countries and thus tend to raise other countries’ interest       production capacity was enhanced in great
rates.                                                           manner. The growth of industrialism dominated
    Interdependence between national economies                   mercantilist thought and economic policies. More
leads to the interdependence between national policies.          liberal and freer laissez-fair policy minimized the
When a government cuts taxes to stimulate domestic               government role in economic activities. The
demand, it stimulates demand in international markets            liberalization in the economies helped world trade
too by raising its imports, and thus helping to raise            to flourish. The classical economists measured the
other countries’ exports. Other governments must,                gain from trade by the increase in efficiency that
therefore, modify their policies in order to stabilize           could be achieved by concentrating on those
their own economies. A change in one country’s                   activities in which an economy had a comparative
exchange rate translates automatically into changes in           advantage. Emphasis was also given on the
the other countries’ exchange rates. The domestic                exploration of more raw materials sources to
effects of a change in the exchange rate are less                meet the demand for industrialization. Similarly,
432    NEPAL RASTRA BANK IN FIFTY YEARS

    sources of agricultural products were also             free trade system. As there is a greater tendency of
    developed for many countries. Demand for these         advantages from the division of labor in production,
    products and the chain of innovations caused           free trade is also desirable for international division
    changes in economic and trade activities.              of labour, which allows every country to specialize
• Modern economists measure the gains from trade           in the production of those commodities in which it
    in much the same way as the classical economists.      has greater advantages. The main argument of this
    However, they pay much attention to the role of        theory was such that if a country gains absolute cost
    government.                                            advantages in a particular commodity and
    Massive innovations in various fields of               disadvantages in another commodity over the other
production and economic and commercial                     countries, there is a possibility of trade and
competition gradually strengthened the world               participating countries can gain from it. Accordingly,
economy and trade before the First World War.              specializing on a product in which it experiences an
However, the war hampered the production capacity          absolute cost advantage, and to export it in exchange
and thereby trade. But the post-war reconstruction         for the product in which it has an absolute
along with foreign loans helped to increase the            disadvantage, not only the participating countries
activities of the external sector. Accordingly world       maximize their production but the world output can
trade increased drastically. The Great Depression of       also be maximized without increase in the cost of
1929 caused massive unemployment, financial                production. However, this theory does not answer
instability and economic insecurity. As a consequence      questions about what happens if one of the countries
of the depression, development of protectionism            produces both the commodities more efficiently and
and groupings among countries for trade appeared           cheaply than the other. Adam Smith’s follower, David
which developed the impediments in free flow of            Ricardo, corrected the weakness of this theory.
world trade. Due to the negative impact of the
                                                           Comparative Cost Theory
Second World War, the external sector activities
                                                              David Ricardo’s Comparative Cost Theory is the
deteriorated. However, the postwar reconstruction
                                                           modification of Absolute Cost Theory of Adam
and independence of several colonies created new
                                                           Smith. This theory shows the possible benefit that
markets all over the world leading to greater scope
                                                           the trading nations can gain even if one country gains
in international trade. International co-operation like
                                                           absolute advantages in both the commodities and
General Agreement on Tariff and Trade (GATT)
                                                           the other experiences absolute disadvantages. A
set up in 1947 to reduce trade barriers among nations
                                                           country which experiences absolute advantages in
and United Nations Conference on Trade and
                                                           both of the commodities should specialize in that
Development (UNCTAD) set up in 1964 for solving
                                                           production which provides it comparatively greater
trade problems of less developed countries had
                                                           advantages over the other commodity; and the other
basic objectives of minimizing restrictions on
                                                           country should specialize in that commodity which
international trade and boosting it entirely. Similarly,
                                                           provides it less disadvantages. By exchanging two
regional organizations were also established to
                                                           specialized products between the two countries, they
expand trade and financial flows in regions.
                                                           can mutually benefit from trade.
Theoretical Basis of International Trade                      Some limitations such as labour being the only
   Gains from trade were systematically presented          element of cost of production, homogeneous
on theoretical basis by Adam Smith in his book “The        labour, constant returns in production, no trade
Wealth of Nations” in 1776. The reasons for and            barriers, no transportation cost are the main
gains from trade were analysed through the absolute        arguments put forward against the comparative cost
cost difference in the production processes among          theory. However, other economists later worked to
various nations. That is why his version is known as       overcome the weaknesses of Ricardo’s trade theory..
Absolute Cost Theory of Trade.                             Opportunity Cost Theory
Absolute Cost Theory                                           Gotterfried Haberler in 1933 developed a theory
                                                           in terms of the opportunity costs by including all the
   The Absolute Cost Theory was developed on
                                                           factors in the valuation of goods. Opportunity cost
the basis of the principle of division of labour and
                                                           means the rate at which one commodity is being
                                                                     INTERNATIONAL TRADE AND PAYMENTS       433

sacrificed for obtaining a certain amount of other        has been increasing gradually and the country has
commodity. This theory says that cost of a                established trade relations with more than hundred
commodity is the amount of the second commodity           countries.
that must be given up in order to release just enough
                                                          Trade Promotion Efforts in Development
factors of production or resources to be able to
produce one additional unit of the first commodity.
                                                          Plans
                                                             Nepal virtually had a free trade policy before
Heckscher-Ohlin Theory                                    1956. With the launching of the development plans
    Eli Heckscher in 1919 and Bertil Ohlin in 1935        since 1956, external sector has been given an
developed the factor proportions theory which is          important place as depicted below:
known as Heckscher-Ohlin theory. This theory says         • The first Five Year Plan (1956-61) emphasized
that a country will specialize in the production and         on the establishment of industries producing basic
export of goods whose production requires a                  necessities and exportable. The focus of the plan
relatively large amount of the factors with which the        was to develop industrial sector, to enhance
country is relatively well endowed. According to the         production and to expand export, giving priority
theory, trade between nations is profitable when it          to attain balanced development of the economy.
enables itself to take advantage of the differing            Market expansion also was emphasized in this
factor endowments. Therefore, it is advantageous for         plan. During the plan period, an Import-Export
labour-abundant countries to specialize and export           Advisory Board was established comprising the
labour intensive goods and for capital-abundant              combination of private sector and the
countries to specialize and export capital-intensive         government. In 1961, the industrial legislation was
goods. The theory considers factor endowment in              introduced which was the beginning step to
relative terms, i.e, comparison of ratio of one to           protect the domestic industries on the ground of
other factors of production.                                 infant industries argument, balance of payment
Protectionism in Trade                                       adjustment and employment creation. As a result,
                                                             many import-substituting industries were
    Gains from trade as stated by the trade theories
                                                             developed behind the restrictive trade regime.
can be attained only in the case of free trade without
                                                             However, there were only a few export industries.
any restriction. However, in practice, countries impose
                                                             The primary products, such as rice, oil, timber
trade restrictions through various forms of import
                                                             and raw-jute dominated exports. Exports were
control measures, namely, tariffs and non-tariff
                                                             regulated through export licenses and taxes, which
barriers. Tariffs are custom duties whereas non-tariffs
                                                             were mainly designed to raise government revenue
are fixation of quota, exchange control measures and
                                                             and ensure adequate supply to the domestic
determination of product standards and so on.
                                                             market at low prices.
International Trade in Nepal                              • The subsequent plan, i.e., Second Three Year Plan
    Although the foreign trade statistics of Nepal has       (1962-64) placed a heavy emphasis on increasing
been recorded since only the fiscal year 1956/57, the        industrial production, employment creation and
Nepalese history gives the evidence of the occurrence        diversification of trade. Stress was also given to
of foreign trade in the country with neighboring             reduce import of consumption goods, to increase
countries, India and Tibet, much before that. After          foreign exchange earnings and to improve the
the Rana regime, Nepal’s trade relation began to             balance of payments position.
expand along with other modernization process of          • The Third Five Year Plan (1965-70) stressed on
the country. Institutionalizing the external sector          the increase in the production of existing and
performance of Nepal was started with the                    potential exportable goods, expansion of trade
beginning of development plans in 1956. Realizing            towards overseas countries and maintenance of
the fact that foreign trade is the appropriate means         quality, change in the composition of imports by
for rapid economic development, the country is giving        reducing imports of consumer goods, and
importance to the sustainable development of the             diversification of trade. In the plan, emphasis was
external sector adopting trade promotion policies in         given to export promotion to earn foreign
different times. Consequently, the volume of trade           exchange so that capital goods required for the
434    NEPAL RASTRA BANK IN FIFTY YEARS

  industrial growth could be imported in adequate            major change occurred in the export structure
  manner.                                                    during the plan period with woolen carpet
• The Fourth Five Year Plan (1971-1975) stressed             replacing jute and jute goods as the main item of
  on the provision of necessary assistance as an             export. However, the increase in the international
  incentive to promote the export of manufactured            price of construction materials, petroleum
  goods. The plan emphasized on the export of                products, chemical fertilizer and other
  semi-processed and processed goods instead of              commodities essential for development programs
  exporting them in the form of raw materials. It            exerted upward pressure in imports.
  was planned to double export to other countries          • The Seventh Five Year Plan (1986-91) gave
  gradually adopting the policy of commodity and             emphasis to export promotion setting the
  country diversification during the plan period.            objectives as: to make the balance of payment
  Quality improvement and extension of credit                situation more favourable gradually through
  facilities were the objectives set forth in this plan.     expansion and development of the export sector,
• The Fifth Five Year Plan (1976-77) included such           to create necessary infrastructure to make the
  trade policy that laid emphasis on increasing and          imports of goods essential for national
  diversifying the international trade. The objectives       development, and to maximize the benefits from
  of the plan were to regularize and guide internal          foreign trade to the national economy by making
  and external trade for economic and social                 the transit system more efficient and less expensive.
  development, to manage and supply regularly
  consumer goods as well as developmental                    In order to fulfill these objectives, some major
  materials, to maintain favourable trade balances,          policies were also adopted as to expand export
  to change trade structure and diversify the trade          sector through the increase in domestic
  on country-wise and commodity-wise basis. For              production and through standardization of the
  the fulfillment of the objectives, some policies           produced goods to make necessary amendments
  were addressed in the plan period, such as to              in related rules and regulations, to expand the role
  prohibit and discourage the import of luxurious            of private sector for export promotion, to
  goods by increasing custom tariffs, to operate             enhance the effective trade and supply activities
  the foreign trade in an organized and                      mobilizing the Trade Promotion Center, Nepal
  institutionalized way, and in the context of trade         Transit and Godown Co. Ltd., National Trading
  diversification, to emphasise on neighbouring              Ltd., Cottage Industries Export Development
  countries for increasing trade on the basis of             Project, Nepal Oil Corporation and so on. Some
  economic viability.                                        major changes made in the external sector during
• The Sixth Five Year Plan (1982-87) set forth the           the Seventh Plan were: devaluation of Nepalese
  trade related objectives separately for export and         currency by 14.7 percent under the Structural
  import business. The export related objectives             Adjustment Program (SAP) in December 1985,
  were: to provide employment and income                     introduction of open general license (OGL) and
  resources to the people through export trade, to           auction system, cash subsidy scheme etc. In order
  increase export capacity and support balance of            to promote export and import trade, warehouses
  trade, and to develop international relations              were constructed in the border customs areas.
  through technology and skill development.                • The Eighth Five Year Plan (1992-97) set the trade
  Similarly, the import related objective was to             related objectives as: to create more income and
  facilitate imports of capital goods, construction          employment opportunities, to attain a favourable
  materials, and high volume products not available          balance of payments enhancing the export
  in the country. In order to fulfill these objectives,      business, to diversify international trade by
  some working policies were also set forth, such            promoting backward linkages, to expand
  as to increase the export of low weight and high           employment oriented trade in harmony with other
  value products, to develop the “Export and                 economic sector, and to make transit facilities
  Import Plan”, and to protect national industry             efficient and effective in order to channel optimum
  by strengthening “Border Administration”. A                benefit from foreign trade to the economy. To
                                                                      INTERNATIONAL TRADE AND PAYMENTS      435

   achieve these objectives, some policies were set          program, quality standardization and
   forth, such as to adopt the liberal and dynamic           improvement of export products, special export
   trade policies, to define the role of government          promotion program, import management and
   as a facilitator, to put emphasis on quality              simplification program, infrastructure building,
   production of goods and services, to increase             and organizational arrangements were included
   commodity-wise and country-wise trade, to                 in the plan. During this plan period, Nepal India
   correlate trade sector with other sectors, to design      Trade Treaty was signed with very favourable
   appropriate monetary and fiscal policies, to              provisions to Nepal’s exports to India, which
   provide necessary institutional facilities and            helped to expand trade activities with that country
   information network, to implement promotional             in a beneficial manner. The construction of Dry
   programs, and to provide warehousing facilities           Port was completed during the Ninth Plan period.
   to reduce the transit cost and so on. The major           During the same period, an export promotion
   working policies were to implement product                seminar was held in Kathmandu with a view to
   diversification and enhancement of quality                expand foreign trade to various countries and to
   standards of existing commodities, such as                familiarize Nepal’s trading image in the
   woolen carpets, readymade garments, leather and           international market. The liberal provisions
   leather goods, handicrafts and jewelleries, lentil        accorded by the Nepal India Trade Treaty, 1996
   and spices, the extension of sheep farming for            helped to enhance industrialization in Nepal. With
   raw materials, development of textile industries          a view to promote export of readymade
   through the attainment of increased production            garments and make it sustainable, an agreement
   of cotton crops, promotion of foreign and joint           was reached with the European Union in 1999.
   investment, changes in production technology and        • The Tenth Five Year Plan (2002-07) stressed on
   promotion of new export markets. During the               the objective of expanding foreign trade and
   Eighth Plan, a new commerce policy was                    policies and programs for making the trade sector
   implemented in 1992 in accordance with the aim            liberal and market-oriented. The long-term vision
   of making the commerce sector liberal,                    of the plan has been stated as “the trade sector
   competitive and market oriented. Similarly, an            will be integrated to the globalization process and
   Export Promotion Fund was established to                  will be made competitive and market-oriented
   for mulate, monitor, and evaluate export                  to develop it as a strong foundation of the
   promotion program and trade agreement                     economy”. The major objectives of trade sector
   between Nepal and India was renewed with                  are to integrate import to industrial development,
   comprehensive amendments. The other                       to promote export so as to increase the overall
   development included initiating action to join the        contribution of the trade sector to the GDP, and
   World Trade Organisation (WTO).                           to enable people at all levels to utilize gains of
• The Ninth Five Year Plan (1997-2002) had set               domestic and foreign trade through maximum
  the trade related objectives as: to make maximum           participation of the private sector under liberal,
  utilization of commerce sector for economic                competitive and market-oriented economic
  development of the country, to expand the                  environment. The major strategies of the Tenth
  benefits of foreign trade to rural areas, to diversify     Plan are: making the trade sector liberal and
  international trade and strengthen backward                market-oriented to speed up foreign trade,
  linkages in order to make export trade stable. In          diversification of exports both commodity wise
  order to fulfill these objectives, emphasis was            and country wise, maximum use of local raw
  given to enhance the export-oriented productions           materials in domestic industries, strengthening of
  that have comparative advantages, to utilize the           forward and backward linkages of exportable
  locally available resources and materials, and to          items, integration of the trade sector in
  promote the export of low weight and high value            globalization process, continuity to promote the
  products. A number of programs for                         participation of the private sector and to make
  implementation, such as product development                the overall trade sector open and competitive.
  program, market development and expansion                  Similarly, membership of WTO, integration of
436    NEPAL RASTRA BANK IN FIFTY YEARS

  import with industrial development, identifying         encouraging interactions between trade and industry
  new exportable products of comparative                  for sustained export promotion and for fulfillment
  advantage and improvement of their quality are          of internal demand through increased domestic
  the other strategies. The strategies for policy level   production, to give emphasis on modernising
  changes are to design and implement a long-term         management and technology, promoting market and
  action plan based on the study of long-term trade       attracting foreign direct investment in order to identify
  and export policy through the participation of          and develop new products. Similarly, the policies for
  the private sector, to improve and simplify the         institutional improvement were to privatise gradually
  existing laws and procedure, to limit the role of       the public sector trading corporations, to formulate
  the government to a facilitator, regulator and          appropriate monetary, foreign exchange and fiscal
  evaluator. The major strategies for import are to       policies and implement them in an efficient, smooth
  identify the areas of comparative advantage and         and transparent basis, to simplify taxation system by
  to create the environment for investment in those       introducing necessary changes in order to foster
  sectors, to develop import trade as a component         competition in trade, to emphasize on institutional
  to the industrial sector and to process and export      development and information network as well as
  locally available natural and other resources           on monitoring system and quality improvement, to
  establishing small and medium scale processing          implement the existing trade treaties and agreements
  industries.                                             with various countries and international agencies
• Nepal’s accession process in WTO was finally            effectively, and to conclude new treaties and
  completed when its membership was approved              agreements as and when necessary.
  by the fifth Ministerial Conference at Cancun,              The major policies for export promotion were
  Mexico and Nepal became the 147th member                to promote exports by increasing the quality and
  of the Organization on April 23, 2004.                  quantity of production of traditional as well as new
                                                          products, to diversify exports of goods and services,
Trade Policy 1992
                                                          to place more emphasis on the export of profitable
    The major objectives of Trade Policy, 1992 were:
                                                          but processed and finished products, and to identify
to increase domestic and international trade through
                                                          new markets. Export of hydro-electricity on a
the creation of open and liberal environment in the
                                                          profitable basis, transparent, smooth and efficient
economy with the growing participation of the
                                                          administrative procedures, effective implementation
private sector, to diversify trade by identifying,
                                                          of the duty drawback scheme for the refund of
developing and producing new exportable products
                                                          import duty paid on the importation of raw materials
through the promotion of backward linkages for
                                                          and intermediate goods required for the production
making export trade competitive and sustainable
                                                          of exportable products, exemption of duty on
establishing backward linkages, to expand trade on
                                                          import of raw materials taking into consideration
a sustainable basis through the gradual reduction in
                                                          the needs and the introduction of bonded
trade imbalances, and to establish co-ordination of
                                                          warehousing system for the storage of such materials,
trade with other sectors by expanding employment-
                                                          establishment of Export Promotion Zones (EPZ),
oriented trade.
                                                          simple and convenient procedures relating to pre-
    The policies adopted to achieve the above
                                                          and post-shipment credits on a priority basis and so
mentioned objectives were: to minimize the role of
                                                          on were the export strategies. Likewise, some import
public sector and to expand the role of private sector
                                                          strategies were to plan imports as a medium of export
in trade, to pursue a liberal and dynamic trade policy
                                                          promotion, to create a competitive industrial and trade
with the objective to improve balance of payments
                                                          environment, to ease the supply of materials required
position by promoting exports, to increase
                                                          for the country through the optimum utilisation of
production of quality goods and services for internal
                                                          available resources were the major import policies. In
consumption as well as for exports through effective
                                                          this context, to simplify import licensing and control
and appropriate utilisation of economic resources,
to make special efforts to promote and diversify trade    system, to reduce transit costs and to minimise
both in the range of commodities and country              pilferage and to make import procedures and
destinations, to adopt liberal procedures for             documentation short and simple and so on.
                                                                       INTERNATIONAL TRADE AND PAYMENTS        437

Foreign Exchange Ar rangements for                          second rate. For all imports, except of specified list
Export Promotion                                            of goods, foreign exchange used to be provided in
    In order to increase exports, the production base       the second rate as well. Through this system, effort
must be enhanced, which requires adequate level of          was made to provide a stable basis for export
investment. In case of inadequate domestic capital,         promotion as all the exporters were guaranteed a
it would be desirable to attract foreign investment.        fixed and attractive exchange rate for their proceeds.
However, foreign investment can be expected where           However, the expected result could not be achieved
trade environment is favourable and attractive              due to the tendency of over-invoicing for exports
because investors would expect better physical and          and under-invoicing for imports. As mentioned
financial infrastructure, existing rules and regulations,   above, exporters could obtain exchange facility at a
and backward linkage and forward linkage facilities         higher rate for their proceeds and earn more money
before investing. In this context, improvement of           in terms of Rupee. So, their tendency became over-
trade, both of import and export, is essential. This is     invoicing the exports. Similarly, as importers would
because, for the enhancement of production base             have to buy foreign currencies at a higher rate, they
and export, capital goods and raw materials are to          tended to under-invoice their imports to avoid the
be imported and it needs adequate foreign exchange          larger custom duty.
which can be obtained from exports. Considering             Adoption of Flexible Exchange Rate System
this, Nepal has been undertaking various measures           [Currency Basket System] (1983)
from time to time for export promotion and
                                                                For the enhancement of export competitiveness
diversification. In this context, Nepal’s efforts to
                                                            in international market, a country’s exchange rate
promote exports through the foreign exchange
                                                            should have a reasonable value. Such reasonable value
arrangements are discussed below.
                                                            could be obtained through the flexible exchange rate
Exporter’s Exchange Entitlement Scheme                      regime. Considering this, Nepal shifted towards
(1963)                                                      flexible exchange rate regime partially, adopting the
    This scheme used to be known as the Bonus               currency basket system in 1983. In this system,
System, which existed for about 15 years. Under this        exchange rate of Nepalese Rupees used to be
system, exporters who were capable of exporting             adjusted with the change in the value of major trading
the countries other than India and earning convertible      currencies except Indian Currency (IC). After the
currencies used to be provided bonus certificate,           adoption of this policy, exports increased
which was to be used for the purpose of importing           significantly. When the basket system was adopted,
goods from those countries. Thus, in order to import        exchange rate of US dollar was Rs. 14.20 and when
from third countries one had to export first and get        the system was removed formally in 1992, it surged
bonus certificate. This system contributed significantly    up to Rs. 43.10. Out of total increase of Rs. 28.90,
in the process of diversification of Nepal’s exports        about two-third depreciation was through self-
to third countries. However, some problems like             adjustment (Nepal Rastra Bank, 1996). However, in
uncertainty in bonus premium value and price                the context of fixed exchange rate with IC, such
instability could not persuade exporters to envisage        system would create broken cross rates between
vigorous endeavor to undertake sound and persistent         Nepalese and other convertible currencies. In order
export efforts. Besides, it was not sufficient to create    to correct such discrepancies, the Rupee was devalued
an environment for adequate supply of essential and         in three occasions by the government. In order to
development related goods. Therefore, the country           further facilitate foreign trade, Nepal adopted partial
adopted the dual exchange rate system.                      convertibility system in1992 and then subsequently
                                                            full convertibility in 1993 in current account.
Dual Exchange Rate System (1978)
    For the correction of lacunas, the bonus system         Forward Exchange Rate Facility
was replaced by the dual exchange rate system. In              After the giving up of fixed exchange rate regime,
this system, there were two rates: basic rate (lower)       some uncertainty was introduced in the domain of
and second rate (higher). All the foreign currencies        convertible exchange rate. The worry of importers
earned through exports were to be exchanged at the          was the expected increase in exchange rate and of
438    NEPAL RASTRA BANK IN FIFTY YEARS

exporters, the probability of exchange rate going           1990 as Group A: essential raw materials, Group B:
down. Considering that importers normally have the          basic consumer goods, Group C: luxury goods,
option of passing on the burden of depreciation of          Group D: goods which are highly liable to deflection
currency to consumers, but exporters have to                to India, and Group E: those consumer goods which
compete in the global market and therefore, any             are largely handled by small traders who could not
additional cost which they might have to incur due          meet the minimum required amount of an import
to the adverse movement of the exchange rate would          license.
have to be absorbed by themselves, the system of
                                                            Open General License
forward exchange rate facility was introduced in the
                                                                 Along with the adoption of foreign exchange
country only for the interest of exporters. This facility
                                                            liberalization through the introduction of partial
was to be made available only in the case of US
                                                            convertibility, open general license (OGL) facility was
dollar through the commercial banks. All the
                                                            implemented in a phase-wise basis. Except for certain
transactions conducted with the clients by the
                                                            specified items, all other items came under OGL. With
commercial banks were to be covered with the
                                                            the facility of OGL, both imports and exports took
central bank.
                                                            a marked speed. Exports reached Rs. 19.3 billion in
    Since the system was for the protection of
                                                            1993/94 from Rs. 5.2 billion in 1989/90 and registered
exporters from any unforeseen downward
                                                            the annual growth of 43.3 percent in 1990/91; 85.5
movement of the foreign currency, the rate quoted
                                                            percent in 1991/92; 26.0 percent in 1992/93 and 11.7
by the central bank always used to be in discount
                                                            percent in 1993/94. However, in 1994/95, exports
rate. The logic behind this was that the exporters
                                                            declined because of not maintaining the international
would go for such facility only when there is a
                                                            requirement in carpet production. Similarly, imports
probability of exchange rate going down.
                                                            reached Rs. 51.6 billion in 1993/94 from Rs. 18.3
Throughout the period, since the normal movement
                                                            billion in 1989/90. During this period, diversification
of US dollar/rupee exchange rate implied consistent
                                                            also took place in a significant manner.
depreciation of the domestic currency, practically
exporters did not have any pessimistic view of the          Partial Convertibility
changes in the exchange rates. Therefore, the exporters         In order to facilitate trade and thereby to promote
seldom used this facility. Such system was ceased by        export, “partial convertibility” policy was adopted
the NRB after the adoption of partial convertibility        in 1992 allowing the exchange rate of convertible
in 1992.                                                    currencies to be determined by the market forces. In
                                                            this system, market rate was applicable to 65 percent
Import License Auction System
                                                            of export earnings in the beginning and subsequently
    Exports and imports are usually interlinked. In
                                                            it was increased to 75 percent.
order to enhance production base and thereby
exports, adequate capital goods and raw materials           Full Convertibility
have to be imported. For example, the boom in the               Nepalese rupee was made fully convertible for
export of carpets took place only when the import           the current account transactions in 1993. Under this
of raw wool required for it was made open in 1987.          policy all the foreign currency proceeds were
Before that, only a few importers were allowed to           permitted to convert at market rates. Exporters were
import raw wool from abroad. As a result, wool              permitted to retain 100 percent of their earnings in
always used to be in shortage and used to carry             their foreign currency accounts and foreign exchange
premium in the market. Consequently, the country
                                                            facility for a large number of items was easily made
could not manufacture and export the woolen carpets
                                                            available. This system exists now as well.
to the extent it was possible, using the competitive
                                                                After the full convertibility, Nepalese export has
strength of the country. Therefore, imports also
needed to be liberalized and facilitated. Considering       taken relatively a higher speed. It has increased
this, the import license auction system for the import      throughout the years (except in 1994/95 due to the
of 88 classes of commercial goods was introduced            fall in carpet export as mentioned above).
dividing these goods into 3 sub-groups in 1986 and              Along with full convertibility, there are other
further refining and increasing the groups into 5 in        policies in effect to encourage export-oriented
                                                                          INTERNATIONAL TRADE AND PAYMENTS        439

industries for capacity enhancement and                        speed except in fiscal years 1986/87, 1994/95 and
diversification of export. Exporters and other foreign         2001/02. During this period, export diversification
exchange earners are allowed to open foreign                   also could be observed in an adequate manner. For
exchange account and to keep 100 percent of their              example, in 1983/84, the share of export to India in
foreign exchange earnings in such account. In order            total export was 68.1 percent and that to other
to enhance the export base, exporters are provided             countries was 31.9 percent. In 1988/89, the former
export and pre-export credit at a concessional interest        came down to 24.7 percent and the latter went up
rate. Similarly, exporters and tourism related bodies          to 75.3 percent. Similarly, in 1993/94, the share of
are provided a facility of foreign exchange for the            India in total export descended further to 12.5
opening up and operation of the liaison office and             percent and the share of other countries surged up
sales and exhibition premises abroad. For the                  to 87.5 percent. Due to the favourable provisions
utilization of this facility, exporters have to fulfill some   accorded by Nepal-India Trade Treaty 1996, Nepal’s
conditions. For the removal of procedural hindrances           export performance remained very encouraging
in the export of the petty items, exporters are allowed        especially towards India. In 1996/97, the share of
to export on bank guarantee rather than letter of              exports to India was 23.1 percent and that to other
credit up to a certain limit. Tourists are allowed to          countries was 64.9 percent. In 1999/2000, the former
carry handicraft products and carpets up to a certain          went up to 42.6 percent and the latter came down
amount. In order to facilitate exporters to have               to 57.4 percent. Although in 2001/02 and 2002/03,
necessary capital at the least cost, pre-shipment and          export growth to India were discouraging due to
post shipment credit in US dollar are made available           the rigid provisions made by the amendment of the
at a concessional interest rate abiding by the existing        Trade Treaty, in 2003/04 and in the six months of
rules and regulations.                                         2004/05, export to India could contribute to total
                                                               export to grow despite the sharp reduction in export
Trends of International Trade
                                                               to third countries. After 1995/96, export to other
    Till the decade of 1960s, almost all of Nepal’s trade
                                                               countries increased continuously up to 2001/02. But
was confined with India. The effectiveness of trade
                                                               in 2001/02, it declined mainly attributing to the fall
promotion and diversification policies could be
                                                               in the export of woolen carpet, readymade garments
experienced since the decade of 1970s. The bonus
                                                               and pashmina resulting from the global recession.
system along with other steps taken by the government
                                                               Because of very poor performance of export to
contributed in the process of trade diversification. That
                                                               other countries, total export declined by 15.6 percent
is because, during the 1970s, the share of other countries
                                                               in 2001/02. As the world economy started to revive,
in total trade began to surge up. In 1956/57 and 1966/
                                                               export of garments promisingly increased in 2003/
67, export to third countries was only 1 percent of
                                                               04 contributing to export to other countries to
total export, while in 1976/77 it went up to 33.1 percent
                                                               increase significantly. However, due to the worsened
and in the following year to 52.4 percent.
                                                               internal security situation, garment industries began
    During the dual exchange rate regime, although
                                                               to close and the export of such item witnessed a
the system was introduced to encourage exports, to
                                                               decreasing trend in 2004/05. As the Multi-Fibre
facilitate imports of industrial raw materials,
                                                               Agreement terminated by the end of 2004, garment
machineries, and other necessities and discourage
                                                               export is facing a tough situation. However, carpet
other (luxurious) imports, the attitude of over-
                                                               export has shown a positive trend during 2004/05.
invoicing of exports and under-invoicing of imports
                                                                   After the adoption of liberalized policies, import
swept the good points of the system. During this
                                                               activities also increased markedly except in 2001/02
regime, exports could not increase; rather imports
                                                               attributing to the decrease in exports, as the Nepalese
surged up nearly three times. Exports increased only
                                                               exports are tied up with the imports of raw materials
to Rs. 1.5 billion in 1981/82 from Rs. 1.0 billion in
                                                               and capital goods.
1977/78. Moreover, in 1982/83 it decreased to Rs.
1.1 billion. But, import reached to Rs. 6.3 billion in         Features of Nepal’s International Trade
1982/83 from Rs. 2.5 billion in 1977/78. After the             Huge share with India
adoption of trade liberalization measures in mid                  Because of its geography, history, culture and
1980s, exports have been increasing in a marked                tradition, India has remained Nepal’s major trade
440    NEPAL RASTRA BANK IN FIFTY YEARS

partner. Till the decade of 1960s, before adopting               Table 2
trade diversification policies, almost all trade used to         Share of Export and Import in Total Trade
be with India. For instance, in 1956/57, 98 percent              (In percent)
of total trade was with India, of which export was                         1956/57    1966/67    1976/77      1986/87 1996/97 2003/04
98.8 percent and import was 97.6 percent. After a
                                                                 Export      35.7       47.0       36.7         21.5      19.5       28.3
decade (in 1966/67), share of India in total trade               Import      64.3       53.0       63.3         78.5      80.5       71.7
was 97.6 percent. India’s share in total trade
                                                                 Source: Quarterly Economic Bulletins and Trade Statistics, Nepal Rastra Bank
continuously diminished after the trade diversification
policies adopted by the country. For example, in
1976/77 such share was 66.9 percent, in 1986/87 it              Huge Trade Deficit in Traditional Manner
was 40.0 percent and in 1996/97 it was 25.9 percent.               Due to the heavy share of import in total trade,
However, because of the easy access of commodities              Nepal’s trade balance has remained always negative.
to and from these countries provided by Nepal-India             For example, trade deficit was Rs. 75.4 million in
Trade Treaty 1996, the share of India in total trade            1956/57 , Rs 55.0 million in 1966/67, Rs. 843.3
began to increase again. It went up to 57.6 percent in          million in 1976/77, Rs. 7.9 billion in 1986/87, Rs.
2003/04.The share of India in total export was 23.1             70.9 billion in 1996/97 and Rs. 82.4 billion in 2003/
percent and that of import was 26.6 percent in 1996/            04. As percent of Gross Domestic Product (GDP),
97. The respective shares in 2003/04 reached 57.1               trade deficit was 5.1 percent in 1976/77. It was 13.2
percent and 57.8 percent (Table 1).                             percent in 1986/87, 25.3 percent in 1996/97 and
                                                                16.6 percent in 2003/04.
Heavy Share of Import in Total Trade
   Nepal is heavily dependent on imports to meet                Export/Import Ratio
the demand for both investment and consumer                         Till the 1970’s decade, export/import ratio used
goods. Since the trade data were recorded, Nepal’s              to be more than 50 percent. At that time, there were
import has been keeping a dominant share in total               restrictions on trade, especially on import. For
trade. In 1956/57, the share of import in total trade           instance, in 1956/57, 1966/67 and 1976/77, total
was 64.3 percent. In 1966/67 and 1976/77, such                  export respectively covered 55.6 percent, 88.6
share was 53.0 percent and 63.3 percent respectively.           percent, and 58.0 percent of total import. Since the
Similarly, in 1986/87, 1996/97 and 2003/04 it was               middle of 1980s, Nepal started to move toward
78.5 percent, 80.5 percent, and 71.7 percent                    liberalization. The effect of liberalization appeared
respectively (Table 2).                                         in the external sector also. Because of this, both

 Table 1
 Share of India and Other Countries
 (In percent)
                            1996/97     1997/98    1998/99    1999/00       2000/01            2001/02       2002/03         2003/04
 Export
    India                     23.1        32.0       35.1       42.6           46.8             59.6            52.9             57.1
    Other Countries           76.9        68.0       64.9       57.4           53.2             40.4            47.1             42.9
 Import
    India                     26.6        30.7       36.7       36.6           47.3             52.7            57.0             57.8
    Other Countries           73.4        69.3       63.3       63.4           52.7             47.3            43.0             42.2
 Trade Balance
    India                     27.7        30.1       37.8       31.4           47.8             47.4            59.8             58.2
    Other Countries           72.3        69.9       62.2       68.6           52.2             52.6            40.2             41.8
 Total Trade
    India                     25.9        31.0       36.2       38.5           47.1             54.8            55.9             57.6
    Other Countries           74.1        69.0       63.8       61.5           52.9             45.2            44.1             42.4
 Source: Quarterly Economic Bulletins and Trade Statistics, Nepal Rastra Bank
                                                                                 INTERNATIONAL TRADE AND PAYMENTS             441

export and import volume began to increase                       2003/04. Similarly, such ratios towards third countries
tremendously. Nepal’s export increase is backed by               were 26.8 percent, 25.3 percent and 40.2 percent in
import growth. For the production of exportable                  1956/57, 1996/97 and 2003/04 respectively (Table
to India, raw materials are mainly imported from                 3).
other countries, whereas for exports to other
                                                                 Composition of Trade
countries, raw materials are imported from India.
                                                                     During the 1970s, around 85 percent of export
Similarly, since the adoption of liberalization policies
                                                                 was covered by primary commodities. During the
in mid-1980s, infrastructural development and other
                                                                 80s, there can be seen a gradual shift towards the
production activities began to flourish which
                                                                 export of manufactured commodities. For instance,
contributed to a surge in the import of capital goods.
                                                                 in 1986/87, 44 percent of total export was covered
Moreover, as the import volume was relatively very
                                                                 by primary commodities. In 1996/97, the share of
high, the export/import ratio revealed a downward                primary commodities dropped to 16.1 percent. After
trend. For example, in 1986/87 such ratio was 27.4               that, it is around 20 percent. Accordingly, the share
percent and in 1996/97 it was 24.2 percent. After                of manufactured products in total export began to
that, ignoring the rear cases, such ratio recorded the           increase since the middle of 80s and reached to above
range of 40 to 50 percent till 2002/03. However,                 80 percent in 2003/04 (Table 4).
because of the rigid provision made by the Nepal                     While looking at the composition of import, the
India Trade Treaty and lower demand for Nepalese                 share of primary commodities was 28 percent in
goods from third countries, the import-coverage                  1976/77. It was about 26.9 percent and 22.4 percent
capacity of export fell further in 2003/04 reflecting            in 1986/87and 1996/97 respectively. From 2001/
39.7 percent export/import ratio. The export/                    02 there was upward sign in such share and reached
import ratio towards India was 56.3 percent in 1956/             to 37.2 percent in 2003/04. Accordingly, the share
57, 21.0 percent in 1996/97, and 39.1 percent in                 of manufactured commodities in total import was

 Table 3
 Export/Import Ratio
 (In percent)
          1956/57 1966/67 1976/77          1986/87    1996/97      1999/00           2000/01     2001/02 2002/03      2003/04
 Total     55.6       88.6      58.0        27.4        24.2           45.9           48.1        43.7      40.2       39.6
 India     56.3       90.5      58.0        30.6        21.0           53.5           47.6        49.4      37.3       39.1
 Other     26.8       34.6      58.0        25.4        25.3           41.5           48.6        37.4      44.0       40.2
 Source: Quarterly Economic Bulletins and Trade Statistics, Nepal Rastra Bank


 Table 4
 Share of Primary and Manufactured Commodities
 (In percent)
                  1976/77 1986/87      1996/97 1997/98 1998/99          1999/00       2000/01    2001/02    2002/03 2003/04
 Export
 Primary
 Commodities         85.5     44.0        16.1       21.0       22.0          16.4        17.4       28.3      22.7      19.4
 Manufactured
 Commodities         14.5     56.0        83.9       79.0       78.0          83.6        82.6       71.7      77.3      80.6
 Import
 Primary
 Commodities         28.0     26.9        22.4       27.3       30.6          29.8        27.1       34.3      37.3      37.2
 Manufactured
 Commodities         72.0     73.1        77.6       72.7       69.4          70.2        72.9       65.7      62.7      62.8
 Source: Quarterly Economic Bulletins and Trade Statistics, Nepal Rastra Bank
442    NEPAL RASTRA BANK IN FIFTY YEARS

around 72 percent from 1976/77 to 2000/01.                 recovered although many problems were resolved.
However in 2001/02, 2002/03 and 2003/04, such              However, in 2003/04, it performed better.
shares slightly declined to 65.7 percent, 62.7 7 percent      Exports treatment under the Multi-Fiber
and 62.8 percent respectively (Table 4).                   Arrangement (MFA) placed an encouraging trend for
                                                           the export of garment. However, it suffered since
Trade Regime
                                                           the latter part of 1990s due to the decrease in demand.
    Nepal’s trade performance has been highly
                                                           Nepalese gar ments have relatively less price
vulnerable. The small basket of exports and a few
                                                           competitiveness than those of other South Asian
destinations have been the chronic characteristics.
                                                           countries and Sub-Sahara countries because of its
Nepal’s export basket is narrowly concentrated in a
                                                           landlocked situation and not getting the facility of
few products (garments, carpets, and pashmina).
                                                           duty free and quota free access in the USA as the
These three products accounted for more than 75
                                                           Sub-Sahara countries.
percent to 80 percent of third countries export and
30 percent to 35 percent of total export in recent         Trade Diversification
years. Moreover, they depend on limited external              Till 1951, Nepal was kept in a state of virtual
markets. Carpets are exported primarily to Germany         isolation from the outside world. Even in the
and garments to the US. Export of pashmina has             launching of First Five Year Plan in 1956, there was
suffered due to the deterioration of quality. With the     no concrete attempt for trade diversification. The
renewed bilateral Trade Treaty between Nepal and           country’s overall trade was solely confined to India
India in 1996, the export of manufacturing products        alone. However, in 1961, the Bonus system was
like vegetable ghee, toothpaste, acrylic yarn, copper      introduced as a step for diversification by the
wire, toilet soap, zinc-oxide and MS pipe showed an        provision of incentives to the exporters to
encouraging trend in the years following the signing       compensate them for the high transit cost due to the
of the Treaty. However, due to the rigid provisions        land locked character. However, due to some
accorded by the amendment of the Treaty in 2002,           weaknesses like export products not being subject
the major contributing items have suffered.                to the discipline of the international market forces
    Nepal started market oriented economic reforms         and the economy not being able to identify its real
in early 1990s increasing its integration into the world   comparative advantages, the expected achievement
economy. The major reforms in this context included        could not be attained.
liberalization of trade and formulation of commerce
                                                           Major Trade Partners in Third Countries
and industrial policies, rationalization of foreign
                                                               In terms of exports, the major trade partners of
exchange regime, adoption of full convertibility in
                                                           Nepal (other than India) with their respective shares
current account, and substantial depreciation with the
                                                           in total exports are: USA (18 percent), Germany (7
US dollar. Because of the adoption of liberalization
                                                           percent), UK (3 percent), Italy (1 percent) and so on.
measures in the external sector, total trade to GDP
                                                           Similarly, with respect to imports, the major trade
ratio increased significantly i.e. from 23 percent
                                                           partners are: Singapore (6.2 percent), China P.R. (3.9
during the 1980s to about 40 percent in the recent
                                                           percent), Thailand (3.1 percent), Malaysia (2.7),
years. Improved trade environment contributed to
                                                           Indonesia (2.3), and Korea (2.2), etc.
export growth markedly during the 1990s. The major
commodities that contributed to this increase were         Balance of Payments
jute goods, pulses, cardamom, rosin, tooth paste,             To choose the right monetary, fiscal, and exchange
vegetable ghee, soap and so on towards India and           rate policies, it is necessary to have a deep
garments, carpets, pashmina, jewelleries, pulses and       understanding of how the international macro
so on towards third countries. However, quality            economy works (Lin Dert, 2002). In this context,
problems and concern over the use of child labour          the balance of payments (BOP) accounts are very
of importing countries in certain factories adversely      useful. These accounts show all the real and financial
affected the export of carpets resulting in the            flows between one country and the rest of the world.
deceleration of its export in the second half of the       Many policy judgements require this type of
1990s. Till 2002/03, the export of carpet was not          accounting information, such as:
                                                                         INTERNATIONAL TRADE AND PAYMENTS        443

• Judging the stability of an exchange rate system           the country. A debit is an inflow of value for which
  is easier with the help of a record of exchanges           residents of the reporting country must make a
  between nations.                                           payment. Generally inflows are credit and outflows
• To spot whether it is becoming more difficult              are debit. Although total credits must equal total debits
  (or more costly) for debtor countries to repay             in balance of payments, it is useful to draw lines
  foreign creditors, one needs BOP accounts.                 through the accounts dividing some flows above the
                                                             line from the other below. Doing so leaves a net
Definition
                                                             surplus or deficit of credits above the dividing line
    According to Kindleberger “The balance of
                                                             (Lindert, 2002). All credits and debits relating to
payments of a country is a systematic record of all
                                                             goods, services, income and transfer are placed above
economic transactions between residents of the
                                                             the line. All assets flows, both private capital and
reporting country and residents of foreign world
                                                             official reserves, are entered below the line. Under
during a given period of time”. The balance of
                                                             the BOP, the trade balance is the export surplus of
international payments is a comprehensive summary
                                                             goods or merchandise alone. Trade balance is
of the international transactions of a country in a
                                                             relatively quickly available. As in most practices, trade
given period of time. An economic transaction is
                                                             statistics can be rapidly collected and reported from
any exchange of value - typically an act in which title
                                                             customs.
to economic goods is transferred, an economic
                                                                  Current account balance is regarded as most
service is rendered or title to assets is transferred from
                                                             informative balance, that is, the net receipts over
residents of one country to residents of another. In
                                                             payments for goods and services plus net transfer. A
this regard, it is necessary to have a good
                                                             current account surplus, i.e., more credits than debits
understanding of the distinction between residents
                                                             in goods, services and transfer, is a measure of how
and non-residents of a country.
                                                             many new claims the nation is acquiring on foreigners
    The International Monetary Fund (IMF) formulates
                                                             and adding to its net foreign wealth. In other words,
the appropriate guidelines for the compilation of BOP
                                                             a current account surplus represents a net foreign
statistics of its member countries. Such guidelines are
                                                             investment inclusive of reserve accumulations.
incorporated in the BOP Manual, which is amended
                                                             Conversely a deficit on current account means that
time to time in line with the changing pattern of the
                                                             the nation is disinvesting abroad, or becoming more
external transactions. The latest or the fifth edition of
                                                             of a net debtor in order to pay for the extra net
Manual, that was implemented in 1993, has defined
                                                             imports of goods, services and outward giving
BOP as a “statistical statement that systematically
                                                             (Lindert, 2002). Thus, the current account balance is
summarizes, for a specific time period, the economic
                                                             equal to the gap between national production and
transactions of an economy with the rest of the
                                                             national spending.
world.” In other words, a systemic record of all
                                                                  Besides, there are capital and financial balances,
transactions between residents and nonresidents during
                                                             i.e. net inflows over outflows of capital and financial
a given period of time is balance of payments.
                                                             assets. The overall balance compares reserve
Residents in this context represent individuals,
                                                             accumulation with the growth of liquidity liabilities.
companies, governments and so on that are present
                                                             In principle, balance of payment should be zero, i.e.,
in the reporting economy for more then one year.
                                                             receipts and payments should equal. But in most of
Similarly, nonresidents are those who are out of the
                                                             the time, we can see surplus or deficit. When the
reporting economy for more than one year. As per
                                                             receipts from abroad exceed the payments made
the definition, a citizen of a country may not be the
                                                             abroad or inflows are greater than outflows, the BOP
resident of the same country. Likewise, a non-citizen
                                                             is said to be surplus and vice versa.
may be the resident. Foreign embassies, diplomatic
missions and the offices of the international                Correction of BOP Disequilibria
organizations are not residents even though they live           Disequilibrium in the BOP involves inequality
for a long time in the reporting country.                    between demand for and supply of foreign
    In BOP, any transactions have two sides: credit          exchange. The equality between demand for and
and debit. A credit is an outflow of value for which         supply of foreign exchange may be achieved through
an offsetting inflow of value, or payment, is due to         any of the following measures:
444    NEPAL RASTRA BANK IN FIFTY YEARS

(i) Restrictions of imports                                and Nepal’s practice of compiling them are discussed
(ii) Artificial stimulation of exports through subsidies   below:
      and other measures
                                                           Current Account
(iii) Depreciation of domestic currency
                                                              In the current account, there are three main
(v) Deflation of domestic income and prices
                                                           headings as described below.
(v) Attraction of foreign investment/capital by raising
      interest rates and offering other incentives.        Goods
      There are mainly three methods to deal with the           There are two components of goods: exports
condition of disequilibrium (i) changes in relative        and imports, which are recorded in f.o.b. (free on
prices involving changes in internal price level and       board) value.
changes in exchange rates, (ii) income changes                  Normally, oil (petroleum products) is imported
(iii) direct public intervention to shift demand and       from other countries; it is sold to India from Haldia
supply curves.                                             port and is imported again from India through
                                                           different custom points according to the need of
Balance of Payments in Nepalese Context
                                                           Nepal. Before, only the net import of oil (petroleum)
    Nepal started the compilation of BOP statistics
                                                           from India used to be recorded in the BOP; but now,
from 1974/75. For compiling the BOP statistics, the
                                                           if it occurs, all three transactions (import of oil from
guidelines contained in the BOP Manual of the
                                                           other countries, its re-export to India and re-import
International Monetary Fund are followed. The Fund
                                                           from India) are recorded. This is because we can see
formulates appropriate guidelines for the compilation
                                                           the export of oil in new format though it is not
of balance of payments statistics of its member
                                                           produced in Nepal. However, due to some reasons,
countries, which are amended time to time in line
                                                           since 2002/03, oil is being imported from India only.
with the changing pattern of the external transactions.
                                                                Border trade with India, which is not captured in
The first edition of the Manual was published in 1948.
                                                           trade returns, are also adjusted in exports and imports
All member countries are supposed to follow such
                                                           in BOP. Such data are estimated on the basis of the
guidelines for compiling their BOP. By this, not only
                                                           results of surveys of Indian currency notes offered
the Fund can supervise and monitor the external
                                                           for conversion into Nepali rupees and vice versa in
position of its member countries, the particular
                                                           the border areas.
country can also have a consistent BOP statistics,
                                                                Other adjustments that are incorporated in BOP
which accommodates external transactions in a much
                                                           relate to (i) goods procured by non-resident carriers
larger extent. Similarly, more accuracy in global BOP
                                                           in Nepal and resident carriers abroad as export and
can be appeared. Moreover, by doing so, cross-
                                                           import respectively and (ii) exports and imports of
country comparison also becomes much easier.
                                                           electricity to and from India respectively.
    When Nepal started to compile the BOP statistics,
                                                                Data on trade returns are obtained from customs.
the third edition of the Manual was being
                                                           Electricity sale and purchase data are the records of
implemented. The fourth edition of the Manual was
                                                           Nepal Electricity Authority and are obtained from
published in 1977 and implemented till 1992.
                                                           the same body. Similarly, data on the procurement
Although the 5th edition was introduced in 1993,
                                                           of aviation fuel of domestic airlines are provided
Nepal was following the fourth one till April 2003.
                                                           by the airlines themselves. Other data are obtained
However, from May 2003, it began to publish the
                                                           from the International Transactions Reporting System
BOP data according to the latest edition of the
                                                           (ITRS).1
Manual. The currently used BOP statistics format is
relatively more detailed. With a view to                   Services
accommodate more and more transactions with the                Another component of current account, services
rest of the world, some estimates also are made in         consist of transportation, travel, government services
some headings.                                             not included else (n.i.e.), communication services,
    There are three main accounts in the present BOP       insurance services and other services which are
statistics: current, capital and financial accounts.       discussed below.
Before, there were only two main accounts: current             Transportation: Under transportation services, there
and capital accounts. Different components of BOP          are passenger services, freight and other transportation.
                                                                       INTERNATIONAL TRADE AND PAYMENTS        445

Earnings of domestic airlines from non-residents on         securities. In this subhead, if occurred, dividend
international flights come under the sub-heading of         receipts also are included. Since Nepal does not have
passenger services credit. Payments of residents to         foreign direct investment abroad, such receipts for
foreign airlines on international travel are passenger      the time being do not occur. Debit entries represent
services debit. Freights are the charges paid to the non-   payments for electricity purchased from foreign
resident carriers for carrying goods towards the            owned electricity generating enterprises that transfer
destination. As Nepal is a landlocked country, normally     these amounts abroad as dividends, e.g., Khimti and
it does not have receipts of such services except of        Bhote-Koshi electricity projects, and dividends paid
cargo services. Other transportation includes cargo         by other direct investment enterprises to their parent
services and other related services that are not included   companies abroad. Similarly, interest payments for
elsewhere. Data on transportation are mainly derived        external debt are also included in debit entries.
from the ITRS. However, some data are obtained
                                                            Current Transfer
from Royal Nepal Airlines Corporation (R.N.A.C.)
                                                                 Current transfers involve those flows that do not
and non-resident airlines as well.
                                                            incur liability. Under current transfer, there are four
    Travel: The expenditure by nonresidents in Nepal
                                                            heads: grants, workers’ remittances, pensions and
for sight-seeing, entertainment, education, training,
                                                            others in credit.
seminar, health treatment, and so on are incorporated
                                                                 Grants: Grants include government and non-
in the credit side of travel; and expenditure by
                                                            government grants which are recorded separately in
residents for the same purpose as mentioned above
                                                            the detail BOP presentation. The government grants
are incorporated in the debit side. Briefly put, the
                                                            are also separated as cash grants and kind grants in
receipts and payments relating to tourism, medical,
                                                            detail presentation. Under the current transfer, only
educational, recreational and so on come under credit
                                                            those grants are recorded which are granted as food
and debit of travel heading. Data on travel are also
                                                            aid, emergency and relief assistance and other types
collected from the ITRS.
                                                            which are not of investment nature. Grants of
    Government services (n.i.e.): Expenditures by foreign
                                                            investment nature, e.g., project grants and investment
diplomatic missions and by the offices of international
                                                            related technical cooperation, are recorded in capital
organizations in Nepal are recorded as credit where
                                                            transfer under the capital account. Data on cash grants
as expenditures of Nepal’s diplomatic missions
                                                            are derived from the ITRS and grants in kind are
abroad are recorded as debit. Such data are collected
                                                            obtained from the custom records.
from the ITRS as well.
                                                            Workers’ remittances: Workers’ remittances are earnings
    Other services: Other services comprise receipts and
                                                            of Nepali workers abroad, which are sent to their
payments relating to communication services,
                                                            families in Nepal. Earlier, only the remittances coming
insurance services, construction services, professional
                                                            through the formal channel were recorded. But some
and technical services, financial services, royalties and
                                                            surveys and studies conducted in private sector
license fees, cultural services, recreational services,
                                                            claimed that the recorded remittances did not reflect
business services, etc.
                                                            a significant portion of inflows, which come through
Income                                                      the informal channel, namely Hundi. During the mid
   The income account was segregated from the               1990’s gold import was very high, e.g., gold import
services account of the former format which                 in 1996/97 was worth Rs. 31 billion. But such huge
comprises compensation of employees and                     import was not financed from the country; rather it
investment income. Under compensation of                    was financed from outside the country. Such huge
employees, earnings of Nepalese workers (residents)         financing from abroad also justified that huge portion
going abroad for short period are recorded as credit        of remittances was not being recorded. Considering
and payment to non-resident short-term workers by           the continuous outflow of Nepalese workers and
Nepal are recorded as debit. Here, short term or            still inconsistent inflow of remittances through the
short period implies less than one year.                    banking channel, a methodology has been developed
   Under investment income, credit entries reflect          by the NRB to estimate remittances. This
the interest received by NRB and commercial banks           methodology was developed through the interaction
on their holdings of foreign government bills and           with the Labour Department of His Majesty’s
446    NEPAL RASTRA BANK IN FIFTY YEARS

Government, different employment agencies and                  only the direct investment in Nepal is shown in BOP
other related offices. The methodology considers the           presentation. However, there is a problem of
trend of the outflow of Nepalese workers, their                capturing data of such transactions. A sample survey
earnings and the valid period for their stay abroad.           was conducted to collect direct investment data in
    In detail BOP presentation, remittances are shown          2003 without any beneficial results. The sub-
in two heads: institutional and other. Remittances             categories of direct investment are equity capital, re-
that flow through the formal channel are put under             invested earnings and other capital. There is no record
institutional subhead and estimated remittances are            of portfolio investment in Nepal.
put under the other subhead. However, in summary                   Other Investment: Other investment is a residual
balance of payments, both are combined and put                 category not covered in direct investment and
under the heading of workers’ remittances.                     portfolio investment. Under this heading, assets and
    Pensions: Pensions represent receipts by retired           liabilities are shown separately and subdivided by
Nepali solders from British and Indian government.             instruments, by sectors of creditors and debtors. Such
Up to now, there is no record of pension payment.              instruments are trade credits, loans, currency and
    Other (Indian Excise Refund): Excise duties levied on      deposits, and other assets and liabilities.
imports from India, which are imported directly from               Trade credits: Trade credits are the difference
manufacturers, are refunded to the Nepalese government         between the amount actually exported or imported
by the Indian government. Such amounts are kept under          and the amount actually received from and paid for
“other” heading of current transfer in the balance of          those trading activities. Trade credit assets for India
payment. Institutional remittances, pensions and other         are calculated as the difference between actual exports
transfers are obtained from the ITRS as well.                  and foreign exchange received, whereas trade credit
    The combined performance of goods, services,               liabilities are calculated as the difference of the actual
                                                               imports and foreign exchange paid. For third
income and transfer accounts reflect the position of
                                                               countries, data on trade credit assets and liabilities
the current account. In Nepal, ignoring the exceptional
                                                               are compiled on the basis of change in export bills
cases, deficit in current account had been a traditional
                                                               outstanding and import letters of credit outstanding
characteristic of BOP in the past. However, at present,        respectively by taking the difference of such data
as the workers’ remittances have increased substantially,      from point to point basis. If trade credit assets
a significant surplus appears in the current account.          increase, the amounts are shown in negative sign and
Capital Cccount                                                vice versa, whereas if trade credit liabilities increase,
    The former capital account (of earlier format)             the amounts are shown in positive sign and vice versa.
has been expanded and redesigned as the capital                    Other assets: Other assets reflect the contra-entry
                                                               of estimated remittances remaining after deducting
account and financial account. Capital account in the
                                                               gold and silver imports. As mentioned earlier, such
present BOP format consists of two categories: (i)
                                                               imports are financed from outside the country. The
capital transfers and (ii) acquisition or disposal of          remainder of estimated remittances are supposed to
non-financial assets. In the former BOP presentation,          be the addition of assets of the other (private) sector.
capital transfer also was kept under the current                   Under loan liability, government and other sector
transfer. Capital transfer is the transfer of investment       drawings and repayments are included. Data on
nature. It may be in cash or kind. Debt forgiveness is         government drawings and repayments are obtained
also included in capital transfer if it occurred. Similarly,   from Financial General Comptroller Office,
if it can be captured, migrants’ transfer is also              (FCGO) and other sector’s drawings are collected
included in capital transfer of other sectors.                 from commercial banks.
                                                                   Currency and Deposits: Currency and deposit heading
Financial Account                                              comprises the deposits of nonresidents with NRB
    Financial account consists of direct investment,           and commercial banks. Data on currency and deposits
portfolio investment, other investment and reserve             are derived from the balance sheets of NRB and
assets.                                                        commercial banks.
    Direct investment: Direct investment abroad and
direct investment in reporting economy are                     Net Errors and Omissions
accommodated under direct investment heading.                     Unidentified and missing amounts of different
Since there is no record of direct investment abroad,          headings fall in net errors and omissions heading.
                                                                           INTERNATIONAL TRADE AND PAYMENTS         447

Reserves and Related Items                                     surplus as percent of GDP in 2000/01, 2001/02,
    The reserve assets of NRB include monetary gold,           2002/03 and 2003/04 were recorded as 4.9 percent,
holdings of SDRs (Special Drawings Rights), reserve            4.3 percent, 2.6 percent and 2.9 percent respectively.
position in the IMF and foreign exchange holdings              The overall BOP of Nepal normally remains in
of the NRB. Reserve assets of commercial banks                 surplus contributed by the current account surplus
are their holdings of foreign exchange. Use of fund            and inflows of miscellaneous capital. In Table 5, the
credit is treated as reserve related item because such         overall BOP is in deficit by Rs. 3.3 billion in 2001/
item is obtained for the BOP purposes. If it occurs,           02, whereas in 2000/01, 2002/03, and 2003/04 it is
exceptional financing is also related with the reserves        in surplus by Rs. 5.2 billion, Rs. 4.4 billion and Rs.
because such amount is obtained to fulfill the deficit         16.0 billion respectively. With the favourable BOP,
in BOP situation.                                              foreign exchange reserve of the banking system has
                                                               remained at a comfortable level of Rs.130.2 billion
Structure of BOP                                               with the import coverage capacity of goods for 11.5
     In Nepal, balance on goods is traditionally negative.     months and of goods and services for 9.7 months
Around three-fourth of total trade is covered by               as at mid-July 2004.
import. However, service account experiences the
surplus mainly attributing to the significant inflow in        Nepal-India Trade Relation
travel head. As the payment elements are more than                 Traditionally, the history of trade between Nepal
receipts, the trend of income account is negative. But         and India is very old. The bulk of Nepal’s trade has
due to the significant inflow of grants and workers’           been confined to India. The geographical factor is the
remittances and relatively a negligible outflow of these       most important reason for this as Nepal is locked with
headings, transfer account has been remaining in surplus       India in east, west and south. Although there is China in
traditionally. In the past, ignoring the exceptional cases,    the north, the presence of high Himalaya region along
deficit in current account had been the traditional            the border does not provide that much access to trade
characteristic of BOP. However, at present, as the             flow towards China as compared to India. Other
inflow of workers’ remittances has been substantial, a         reasons for the concentration of trade with India are
significant surplus has appeared in the current account.       religious, cultural and social as well as free access for
If transfers were excluded from current account, there         both countries’ people into each others territories. Thus,
would be a huge deficit.                                       Nepal’s landlocked position, its association with the
     In Table 5, balance on goods reveals a huge deficit       Indian market and its reliance on India for transit routes
for all years. In Nepal, although the services account         are responsible for creation of special relationship in
remains in surplus, it offsets only around 10 percent          trade between these two countries.
of trade deficit. Moreover, as the payments are more           Trade Treaties between Nepal and India
than the receipts, the trend of income account is                  Various trade treaties have been concluded
negative. That is because balance on goods and                 between Nepal and India. The first treaty took place
services as well as balance on goods, services and             with British-India as early as 1923 (Jha, 1987). This
income also show a huge deficit. Current account               treaty waived custom duty on goods imported by the
                                                               government of Nepal through British-India ports
 Table 5                                                       (Shrestha, 1974). Nepal concluded treaty of Trade and
 Position of Current Account                                   Commerce with India in 1950 which recognized
 (Rs. in billion)                                              Nepal’s right of commercial transit of all sorts of
                      2000/01    2001/02    2002/03 2003/04    manufactured and non-manufactured products with
 Balance on Goods        -56.4      -53.4      -70.3   -77.7   the overseas countries through the Indian territory or
 Balance on goods &                                            ports. Provisions like common tariffs for materializing
 services                -47.1      -49.4      -63.2   -68.6
 Balance on goods,                                             the concept of free trade area between the two
 services & income       -45.4      -50.0      -63.9   -70.3   countries were made. Nepal was to levy export duty
 Current Account                                               for those goods in order to make them not expensive
 Balance                  20.2      18.2       11.6    14.6
 Overall BOP               5.2      -3.3        4.4    16.0    than those goods produced in India. Nepal and India
 Source: BOP Statistics, NRB
                                                               both were expected to follow the same tariff policy
448    NEPAL RASTRA BANK IN FIFTY YEARS

not only in imports and exports of goods between                The Treaty of Trade and Transit between Nepal
them but also with other countries (Jha, 1987).             and India concluded in 1971 was replaced by two
    The Treaty of Trade and Commerce was                    separate treaties, Treaty of Trade and Treaty of Transit,
substituted by the Treaty of Trade and Transit of           on March 25, 1978. The former was effective for
1960. The goods originating in either country and           five years and the latter for seven years, after which
intended for consumption in the territory of the other      they were renewed. In the Treaty of Trade, both
were to be exempted from custom duties, other               Nepal and India agreed to extend all possible facilities
duties as well as quantitative restrictions. In this way,   to each other for free flow of essential goods. Both
a provision was made to expand mutual trade of              countries confirmed that they would not be accorded
such goods, which originated in both the countries.         less favourable treatment with respect to custom
Both countries agreed to provide transit facility to        duties and changes in the import and export of goods
one another for their trade with third countries as         and services and import regulations including
well.     The Treaty of Trade and Transit concluded         quantitative restrictions. Similarly, India agreed to grant
on August 13, 1971 made such provisions that both           special favourable treatment on the Nepalese exports
countries would provide each other no less                  of manufactured products to India in custom duty
favourable treatment than they provide to any of            on non-reciprocal basis. The norm of this agreement
the third countries in levying custom duties and other      was to help promote the industrial development of
changes in the import and export of goods as well           Nepal. Therefore, such Nepalese manufactured
as import regulations including quantitative                goods containing at least 80 percent of the Nepalese
restrictions. Thus, the most favoured nations (MFN)         materials or Nepalese and Indian materials were to
treatment was to be prescribed by the countries to          be exempted from basic customs duty and
each other’s goods. Easy access to the primary              quantitative restrictions on their export to India. They
products of Nepal to the Indian market (exempt in           agreed to remove the basic custom duty and
customs duty and quantitative restrictions), non-           quantitative restrictions of the import of primary
reciprocal treatment in respect of custom duty and          product from each other. Both countries committed
quantitative restrictions in the export of industrial       to facilitate the free flow of primary products.
products exported into India, which constituted not         Preferential treatment was accorded to the primary
less than 90 percent of Nepalese or Nepalese and            product on reciprocal basis. Also, they agreed to
Indian materials, freedom of transit across the             cooperate effectively to each other to prevent
territories of either of the two countries for              infringement and circumvention of laws, rules and
legitimate interests, prevention of re-export of goods      regulations of either country regarding matters on
if it contained more than 50 percent of ex-factory          foreign exchange and foreign trade. The Trade Treaty
value were the provisions made by this treaty. Goods        1978 and Transit Treaty 1978 were for five and seven
imported from small units in Nepal were rendered            years, respectively. The former was renewed for next
similar concessions in excise duty given to small units     five years and the latter was extended up to March
in India. The treaty accorded priority to the expansion     23, 1989. After that, these treaties could not be
and diversification of mutual trade of the two              renewed due to some differences among the partner
countries in goods produced in their territories. Nepal     countries. All trade over surface routes with India
was free to impose import duties on Indian products         was restricted to just two border points. This was
on the MFN basis. It was agreed that excise and other       applicable to trade with India, third country trade
duties collected by India would be refunded to the          crossing India, and intra-Nepal trade between central
Government of Nepal to the degree of the import             and western Nepal. (Pant, 1994). MFN treatment
duty charged in Nepal. The two countries agreed to
                                                            was given to each other’s trade. Thus, Nepalese
co-operate with each other to block infringement
                                                            export which had a free access into India had to face
and circumvention of foreign exchange and foreign
                                                            relatively high customs duties, which were MFN
trade laws and regulations (Pant, 1994). Similarly,
transport of goods by road between Calcutta and             custom duties of India. From March 23, 1989 to
Nepal was permitted by the treaty. Warehousing              June 10, 1990 Nepal underwent a phase of non-
facilities and simplification of customs procedures         treaty regime. A troublesome environment hindered
were other provisions in this treaty.                       the trade between Nepal and India.
                                                                      INTERNATIONAL TRADE AND PAYMENTS         449

    However, with the agreement of June 10, 1990,         product for entry to the Indian market free of custom
India was to restore 22 border points for entry of        duties and quantitative restrictions. In other words,
goods into Nepal, to resume supplies of essential         if the total percentage of the three components, i.e.
commodities like coal and petroleum to Nepal. The         the Nepalese labour content, the Nepalese material
Nepalese products possessing not less than 65             content and the Indian material content is more than
percent of Nepalese or Nepalese and Indian                50 percent, the product would have duty free and
materials were to be exempted from the Indian             quota free access to the Indian market. Except a few
basic custom duties and quantitative restrictions.        commodities, all Nepalese export was covered by
Similarly, Nepal was having the benefit of duty-          these provisions (Pant, 1994). In order to facilitate
free facilities, as India was not to impose export        the import of some fixed items, raw materials and
duties on its exports to Nepal. However, imports          capital goods from India, provision of payment in
of some essential commodities for consumption,            convertible currency was made. Similarly, movement
raw materials and construction materials from India       of Nepalese private commercial vehicles from the
were under quota arrangements. Exercise duties            Nepalese border to Calcutta and Haldia were allowed
imposed on the imported goods were to be                  based on the permission given by the Nepal Transit
refunded by India to the government of Nepal              and Warehousing Company Limited or Nepal
under the duty refund procedure. Similarly, Nepal         Transport Corporation.
was to resume tariff preferences to Indian goods.             Nepal India Trade Treaty 1996 signed on
After the normalization of relations between the          December 3, 1996, gave a new direction in the trade
two countries, two separate treaties on trade and         related areas as well as a scope for the trade
transit were concluded on December 6, 1991 with           improvement especially to Nepal. Some of the
the new arrangement for cooperation in controlling        provisions made in the earlier treaties were replaced
unauthorized trade. The term of this trade treaty         and modified making the procedures simple and
was five years with a renewal provision for another       straight in order to remove the procedural delays. It
five years and that of the transit treaty was for seven   committed the cooperation in more specific and
years. The new trade treaty comprised some new            extended manner. Some of the provisions of the
facilities and concessions for Nepalese exports to        treaty are:
India like reduction of Nepalese or Nepalese and          • Access to the Indian market free of customs
Indian material content from 65 percent to 55                 duties and quotas for all articles (except the
percent for duty/quota free access into India.                negative list2) manufactured in Nepal.
However, due to the procedural hindrances and             • Certificates of Origin of such products were to
Nepal’s poor industrial base, the provision of 55             be issued by the agency designated by the
percent material content could not work fully. For            Nepalese government.
instance, though there were 91 Nepalese products          • Each consignment of products manufactured
that were allowed preferential entry into India, the          in the small-scale units in Nepal was to be treated
actual figure turned out to be 25 products. A                 equally as the similar products produced in India.
situation of uncertainty prevailed among exporters            Although the validity of treaty was for 5 years,
for the time period of processing the proforma            there was a provision for automatic renewal unless
forms. Due to slow approval process and levy of           either of the parties gives to the others a written notice
custom duty in India on the items eligible for            of its intention to terminate the treaty. This treaty
preferential treatment, exports did not rise as           was to a greater extent in favor of Nepal.
expected.
                                                          Transit Treaties and Agreement of
    In order to simplify the procedure for export of
Nepalese items to India, an agreement was signed in
                                                          Cooperation to Control Unauthorized Trade
1991. Some modifications were incorporated in the             In order to facilitate the Nepalese trade to third
trade and transit treaty of 1991. These included          countries through India, as mentioned earlier, treaties
abolition of proforma clearance and its replacement       of transit were concluded in different dates normally
by a certificate of origin to be issued by the            with the term of seven years. The latest was concluded
government of Nepal, consideration of Nepalese            in 1999 with the provision of automatic renewal after
labour in evaluating the eligibility of a Nepalese        seven years unless either country gives to the other a
450    NEPAL RASTRA BANK IN FIFTY YEARS

written notice for amendment six months in advance.          yielding low value addition, lack of control in quality
According to this treaty, both countries shall have          standard coupled with international factors such as
freedom of transit across their territories through          economic recession and terrorist attacks had
routes mutually agreed upon. With a view to offer            negative implications in industrial production. This
convenience of traffic in transit, the contracting parties   led to a serious decline in the production of
agreed to provide, at points of entry or exit, warehouse     exportable items and in turn exports, especially third
or sheds, providing treatment no less favorable than         country exports. Moreover, the inability to develop
that accorded to ships of any other foreign country in       industries based on viability and comparative
respect of matter related to navigation, entry into and      advantage, low inflow of foreign direct investment,
departure from the ports, use of ports and harbor            limited expansion of industries in the rural areas,
facilities, loading and unloading dues, taxes and other      low competitiveness, absence of forward and
levies. Some provisions of the former treaty were            backward linkages, and lack of industrial
revised, e.g., only to check the “one time lock” of the      development based on domestic resources, human
containers put on by the shipping agent or carrier. In       resources and raw materials are the major problems
case of broken or defective found, after the thorough        in the trade sector. Among the major exportable
check, again “one time lock” would be posted. There          items, the export of carpets was adversely affected
are 22 land-border points specified for mutual trade         by the use of low-quality wool, export of inferior
between Nepal and India. Calcutta and Haldia ports           carpets from other countries, and issues related to
have been specified as port of entry for Nepal’s third       child labour. Another concern is Nepal’s inability to
country trade by sea. Fifteen land border points have        fully use the transit route via Kakarbhitta-Fulbari-
been specified for the passage of Nepal’s third country      Banglaband to expand foreign trade.
trade. The present transit facilities provided by India           With the expiry of the Multi-Fiber Agreement
to Nepal are:                                                on December 31, 2004 and in the absence of the
• India allows freedom of transit for Nepalese third         alternative market, the garment industry is facing a
     country trade across its territories through routes     tough situation. For the development of the external
     mutually agreed upon.                                   sector, the private sector should be active, sensitive
• Per mission is given for the movement of                   and capable as this sector is the actual player in this
     Nepalese trucks to and from the nearest railway         field. With the accession into the WTO, the country
     stations to pick up the export and transit cargo        still encounters more challenges to survive in the
     to Nepal.                                               global market by increasing the competitiveness with
• Traffic in transit is exempted from custom duty            the enhancement in quality and quantity of the
     and from all transit duties or other charges, except    production. A small basket of exports and very
     charges for transportation and service charges.         limited markets are the other serious concerns.
• Facilities are provided for warehousing and
     storage of goods in transit awaiting custom             Conclusions and Recommendations
     clearances before inward transportation in Nepal            Due to relatively a much larger magnitude of
     through the Indian territory.                           imports, the high trade deficit has been a salient
     In order to control unauthorized trade between          feature of the country’s trade from the beginning.
two countries, agreements were signed in different           Since the implementation of development plans,
dates, the last being in 2002. According to this             trade promotion efforts have been going on.
agreement, both countries would prohibit and                 However, the expected results have not been achieved.
cooperate with each other to prevent re-exports from         Concentration of export trade in a few items and
its territory to each country of goods imported from         destinations, dependence on the import for raw
third countries.                                             materials, weak forward and backward linkages,
Problems and Challenges                                      widening trade deficit, and lack of development of
    Despite the implementation of a number of                infrastructures are the major challenges in the trade
policy and procedural reforms to promote the                 sector. Similarly, the failure to expand trade with
trade sector, several problems still exist. The major        China, despite huge business potential, is another
internal reasons such as closure of industries due to        weakness of the country’s foreign trade regime.
the security problem, high investment in industries          Unless and until there is adequate development of
                                                                          INTERNATIONAL TRADE AND PAYMENTS        451

infrastructure and utilization of locally available natural       trade should be developed as a component of
and other resources, the attainment of comparative                industrial development.
advantage on the production and expansion of trade            •   In order to utilize the locally available resources,
is not possible. With the enhancement of quality and              enhance production at a lower cost and create
quantity of production, trade should be diversified               competitiveness, suitable industries should be
country-wise and product-wise. In order to increase               established on local basis. Emphasis should be
exports, production of exportable must be enhanced.               given to quality production.
New exportable items that have comparative                    •   Necessary arrangements should be made for the
advantage should be identified. Economic liberalization           promotion of foreign investment and technology.
should be reflected in the expansion of production            •   Dry ports should be used to the maximum with
activities, export promotion and higher level of import           the norm of ports not to be just a parking area.
competing rates. In this respect, as the country has          •   Although establishment of export processing
been able now to use the dry ports constructed in                 zones in major custom points has been announced
Birgunj, Biratnagar and Bhairahawa, the                           in various plans, it has not been implemented yet.
competitiveness of the country’s foreign trade can be             The process of setting up of export processing
expected to increase with the reduction in cost.                  zones should be accelerated.
    The government has facilitated the imports of             •   Enhancement of the competitiveness of the trade
industrial raw materials and capital goods. There are             sector in harmony with SAARC, SAPTA and
more than 60 items that can be imported from India                SAGO agreements has been emphasized in the
by paying convertible currencies. But this is not                 Tenth Plan. This should be expedited as well.
enough. Physical infrastructure must be developed.            •   Emphasis should be given to the identification
Then only can industries be established at a local level          of new exportable and enhancement of their
by utilizing local resources. Consequently, income and            production. Quality and quantity promotion of
employment generating activities would be created                 existing exportable items such as, woolen carpets,
for the marginalized group through the promotion                  ready-made garments, pashmina and handicrafts
of small enterprises and through an integrated                    should be expanded.
program to improve skills, entrepreneurship,                  •   Institutional capacity of governmental, non-
investment and technology transfer. This will                     governmental and private institutions related to
significantly contribute to poverty alleviation also. The         export promotion should be enhanced.
production of agricultural and other primary goods            •   The role of private sector should be made decisive
would also be enhanced as the modern tools, seeds,                in the development of external sector.
fertilizers, etc. could reach all regions of the country.         Coordination between government and private
Products would be consumed in the domestic as                     sector is necessary for identification and expansion
well as international markets. Moreover, enhancement              of international markets.
in the production of existing goods that have                 •   It is necessary to reform trade, industrial, foreign
remarkable contribution in exports such as woolen                 investment and other related policies making them
carpet, ready-made garments, pashmina, vegetable                  friendly to the open and market-oriented economy.
ghee, pulses, and toothpaste should be emphasized.            •   With the accession of Nepal into the WTO, it has
    The end of the Multi-Fiber Agreement has forced               been a must for the country to make foreign trade
the garment industry to look for international markets            more simple, reliable, and cost effective. In this
based on its competitiveness. It is important to accord           regard, there should be reform in the area of
priority to the creation of investment-friendly                   laws, rules and regulations as soon as possible.
environment, reduction in the cost of readymade               •   Nepal’s external sector policy should focus on
garments, promotion of quality products, and timely               creation of tourism friendly environment.
import of the required raw materials to meet the future       •   By mobilizing Nepalese foreign agencies, it is very
challenges. For the better performance of the external            urgent to make good arrangement of foreign
sector, some suggestions are presented below:                     employment of Nepalese workers and to regulate
• Areas of comparative advantage should be                        the inflow of remittances. These agencies should
    identified and environment for investment should              be activated also for promoting FDI for
    be created in those sectors. Moreover, import                 industrial development.
452    NEPAL RASTRA BANK IN FIFTY YEARS

• Promotion of foreign investment and technology             National Planning Council. 1963. The Three Year Plan
  in the area of competitive advantage, based on                (1962-65). Kathmandu: National Planning
  the study of demand and supply of goods in the                Council.
  international markets, is necessary. Investment            National Planning Council. 1965. The Third Plan (1965-
  friendly atmosphere is a must.                                70). Kathmandu: National Planning Council.
                                                             National Planning Commission (NPC). 1972. Fourth
Endnotes                                                        Plan (1970-75). Kathmandu: NPC, KAthmandu.
   1
     ITRS is one of the Data Sources to compile              National Planning Commission (NPC). 1975. The Fifth
BOP Statistics. An ITRS measures individual BOP                 Five Year Plan (1975-80), National Planning
cash transactions (passing through the domestic banks           Commission (NPC). Kathmandu.
and foreign bank accounts of enterprises) and no             National Planning Commission (NPC). 1980. The
stock positions. Statistics are compiled from forms             Sixth Plan (1980-85). NPC, Kathmandu.
submitted to domestic banks and from forms                   National Planning Commission (NPC). 1985. The
submitted by enterprises to the compiler.                       Seventh Plan (1985-90). NPC, Kathmandu.
   2
     Negative list of articles that are not allowed          National Planning Commission (NPC). 1992. The
preferential entry from Nepal to India on the basis             Eighth Plan (1992-97), NPC, Kathmandu.
of “certificate of origin” (CoO) include:                    National Planning Commission (NPC). 1998. The
       i. Alcoholic liquors/beverages and their                 Ninth Plan (1997-2002), NPC, Kathmandu
            concentrates except industrial spirits,          National Planning Commission (NPC). 2003. The
       ii. Perfumes and cosmetics with non                      Tenth Plan (2002-2007). http://www.npc.gov.np/
            Nepalese/ non Indian brand names, and               tenthplan/english/ .
       iii. Cigarettes and tobacco.                          Nepal Rastra Bank. Various Issues. Annual Report,
                                                                NRB, Kathmandu.
References
                                                             Nepal Rastra Bank. 1996. 40 Years of the Nepal Rastra
Government of Nepal. 1956. First Five Year Plan
                                                                Bank, NRB, Kathmandu.
   (1956-61), National Planning Council,
                                                             Nepal Rastra Bank. 2004. Macroeconomic Indicators of
   Kathmandu.
                                                                Nepal, NRB, Kathmandu.
International Monetary Fund . 1995. Balance of
                                                             Nepal Rastra Bank. Various Issues. Economic Report,
   payments compilation guide, Washington D.C.
                                                                NRB, Kathmandu.
International Monetary Fund.1993. Balance of payments
                                                             Nepal Rastra Bank. Various Issues. Quarterly Economic
   manual “, Washington D.C.
                                                                Bulletin, NRB, Kathmandu.
Jha, Hari Bansha. 1987. Strategy in Nepal’s Foreign Trade,
                                                             Research and Studies Centre Ptv. Ltd. 2000. A study
   The Forum of Economic Writers, Kathmandu.
                                                                on the Preparation of the long term Export Promotion
Kafle, Shiba Devi. 2001. “Export Promotion
                                                                Plan & Stragies, RESTUC, Kathmandu.
   Through Foreign Exchange Management”, Nepal
                                                             Sethi, T.T.. 1999. Money, Banking and International Trade,
   Rastra Bank Samachar, Special Issue, April, NRB,
                                                                S.Chand & Company Ltd., Ram Nagar, New
   Kathmandu.
                                                                Delhi.
Kafle, Shiba Devi. 2004. “New Blance of Payments
                                                             Shresth, Gyanu Raja. 2003. Nepal-India Bilateral Trade
   Presentation”, Nepal Rastra Bank Samachar, Special
                                                                Relations: Problems and Prospects, Research and
   Issue, April, NRB, Kathmandu.
                                                                Information System for the Non-aligned and
Kenen, Peter B. 1994. The International Economy,
                                                                Other developing Countrise, New Delhi.
   Cambribge University Press, Great Britain.
                                                             Shrestha, Shyam Kumar. 1994. Export Market
Lindert, Piter H.. 2002. International Economics, Rechard
                                                                Management in Nepal: A critical Study, Padma
   D. Irwin, Inc. Homewood, illionois 60430, All
                                                                Educational Traders, New Road, Kathmandu.
   India Traveller Bookseller, Delhi
                                                             Shyakya, Bijendra Man. 1991. Foreign Trade and Export
Pant, Bhubanesh. 1994. Trade and Development: Nepal’s
                                                                Management, Edu.Tech. Nepal Publications,
   Experiences, Oxford & IBH Publishing Co., New
                                                                Kathmandu.
   Delhi.
                                                             Trade Promotion Centre. 2004. A glimpse of Nepal’s
Salvadore. Dominick. 2004. International Economics,
                                                                Foreign Trade, TPC, Lalitpur.
   John Wiley and Sons, Inc., Singapore
                                                                      WTO AND FINANCIAL SERVICES SECTOR        453




                        WTO and Financial Services Sector
                                       Dr. Nephil Matangi Maskay
                                       Deputy Director, Research Department
Introduction                                                             development. In sum, WTO captures a
    Nepal had recently become the 147th                                  very broad foot print which encompasses
member of the global rule based trading                                  all aspects of trade in goods and services.
organization known as World Trade                                        This paper, however, is focused to the
Organization (WTO); this organization                                    Financial Services Sector (FSS) of the
comprehensively covers international                                     General Agreement of Trade in Services
trade in goods and services as well as                                   (GATS).4
intellectual property rights and provides                                       The FSS is crucial for economic
both a certain and stable environment for                                growth and development in general, and
exchange in goods and services (for                                      particularly so for a developing country
background see WTO, 2003). Nepal’s membership              like Nepal which has a per capita GDP of $269 (His
in WTO on 23 April 2004 marked the culmination             Majesty’s Government of Nepal [HMG/N],
of a process that had commenced in 1989 with               Economic Survey, 2003/2004). The FSS has a cross-
application in the General Agreement on Trade and          cutting nature across all sectors of the economy for
Tariff (GATT), which had evolved into the WTO              facilitating (1) financial intermediation in the economy
on 1 January 1995 (WTO, 2004).1 The continued              (i.e. mobilization and allocation of funds) and (2)
motivation for membership in WTO had been to               efficient financial transfers and payments.5 In other
reinforce the process of trade liberalization, initiated   words, a healthy and stable FSS is essential for
in the mid-1980s (NRB, 1996),2 which was reinforced        sustainable economic growth (Levine, 2001).
by the belief that (trade liberalization) it would both    Conversely, instability in FSS can potentially have a
facilitate integration with the global economy and         disastrous economy wide effect seen most
contribute benefits to the domestic economy.3              dramatically in the East Asian crisis where fragility in
    Nepal’s membership in WTO presents a wide              the financial system spilt over to other countries in
spectrum of challenges along with opportunities that       the region.6,7
are waiting to be grabbed (although for a contrary              Nepal is fully aware that with entry into WTO,
view see, Mattoo and Subramanian (2004) and Rose           the country has to make necessary arrangements to
(2004)). The challenges are many but can be reflected      maximize the potential benefits of this opportunity.
most saliently in the need for having a transparent set    Nepal Rastra Bank (NRB), the Central Bank of the
of legal rules which are also consistent with that of      country, has been given the important responsibility
WTO; while the opportunities can best be reflected         for ensuring domestic financial stability (NRB Act
in having a stable trading environment which can act       of 2002). Specifically, NRB is required to (1) regulate
as an accelerator for domestic economic growth and         and supervise the portion of FSS called Banking and
454   NEPAL RASTRA BANK IN FIFTY YEARS

Other Financial Services (BOFS as described in more      trading system that introduced successive rounds of
detail below); and (2) ensure stable mechanism for       more liberalized, stable and predictable trading rules.
trade and payments. In this regard, NRB has                  The general principle of WTO is to have freer,
established a high level committee on WTO matters        fairer, and more predictable trade without
(henceforth known simply as HLC) on May 12, 2003         discrimination and being more beneficial for less
coordinated by the senior Deputy Governor of the         developed countries. The most important principles
Bank8 with members the other Deputy Governor9,           built into the foundation of the multilateral trading
and heads of identified departments/division namely:     system are further discussed:
Bank and other Financial Institutions Regulation         • Trade without discrimination
De partment (BFIRD); Bank Super vision                       • Most-favored nation (MFN): treating other nations
Department (BSD)10; Foreign Exchange Management                  equally – a tariff reduction granted to one
Department (FEMD); Research Department (RD);                     country that has to also be extended to all the
and Legal Division (LD); with the Director of RD                 members countries in the GATT; this is a
in charge of the Special Study Division (SSD) being              multilateralization of the bilateral liberalization.
the member-secretary of the HLC. Further the                 • National treatment: treating foreigners and locals
Secretariat of HLC is presently located in the RD.               equally – countries should not discriminate
This paper aims to overview the process by NRB                   between it’s own and foreign products once
to address the potential challenges with Nepal’s                 they have crossed the border and entered the
membership in WTO with focus on FSS. The specific                market.
objectives of this paper are to:                         • Freer trade: gradually through negotiation – the
• Provide a brief background of WTO and the                  objective is to gradually reduce trade barriers as
    history of Nepal’s membership process;                   one of the most obvious means of encouraging
• Present stylized facts on the Nepalese FSS;                trade.
• Describe the commitments made by HMG/N                 • Predictability: binding commitments – provide stability
    in regard to FSS; and                                    and predictability which in turn widens business
• Provide the (proactive) activity of NRB.                   opportunities; a change in binding has high
                                                             opportunity costs.
Background of WTO and History of
                                                         • Promoting fair competition – a system of rules
Nepal’s Membership Process
                                                             dedicated to open, fair and undistorted
    This section provides a brief overview of WTO
                                                             competition.
and gives a brief history of Nepal’s accession process
                                                         • Encouraging development and economic reform:
into this organization.
                                                             contributes to development, special assistance and
Brief Overview of the WTO, the Global                        trade concession for developing countries,
Rules-based Trading System                                   flexibility in WTO agreements.
    The current institutional framework of the global        The original GATT rules (consisting of 38 articles
trading system – the WTO – was created on 1 January      and nine annexes) have been modified to address new
1995 replacing the then GATT. WTO is a global            international trade challenges but the basic principles
organization dealing with the rules of trade and         have remained the same. One major area of
presently has 148 member countries (WTO home             modification occurred with respect to the treatment
page). Prior to establishment of this organization,      of developing countries when Part 4 (Trade and
trade rules had been developing under GATT to            Development) was added to the original rules. This
meet the evolving needs of the participating countries   ministerial decision was adopted at the end of the
and the global community. GATT entered into force        Uruguay round, which offers least developed countries
in January 1948 by 23 founding member countries          extra flexibility in implementing WTO agreements.
(officially “contracting parties”) to salvage what was   Another major reform occurred with the last
left of the original proposition called the Havana       negotiation rounds, the Uruguay Round, when the
declaration, whose objective was to establish the        entire system was revised and updated to meet the
International Trade Organization. GATT was               challenges of introducing new areas into negotiations.
instrumental in the creation of a strong multilateral    The revised set of rules is now known as GATT 1994
                                                         to differentiate it from the original rules (GATT, 1947).
                                                                               WTO AND FINANCIAL SERVICES SECTOR      455

    During the period of 1948 to 1994, GATT                        • While GATT was dealing only with trade in
presided over eight multilateral liberalization rounds               goods, the WTO covers trade in services and
(see Table 1). Several early rounds were most focused                intellectual property rights as well.
on reducing tariffs and it was not until the Tokyo                 • While GATT’s Dispute Settlement System was
Round that the non-tariff barriers and other issues                  slow and suffered from countries being able to
were introduced into the negotiations. The results of                veto the process, the WTO’s system is faster and
negotiations on those issues were stipulated in several              cannot be blocked.
“codes” which were binding only for the contracting
                                                                   History of Nepal’s Accession Process
parties who signed a particular code (there were nine
                                                                       HMG/N had formally applied for GATT
codes, including inter alia codes on subsidies and
                                                                   membership on May 1989, following a trade dispute
countervailing measure, technical barriers to trade,
                                                                   with India, which had resulted in the establishment of
government procurement, customs valuation, anti-
                                                                   the Working Party for Nepal’s membership in GATT.
dumping and trade in civil aircraft). Finally, the longest
                                                                   However, the trade dispute with India lasted for 15
round so far, the Uruguay Round, introduced
                                                                   months and concluded with new treaties being signed.
negotiations of 15 subjects including three new areas:
                                                                   Hence, the urgency for Nepal to become a GATT
agriculture, services and intellectual property.
                                                                   member, so as to be protected under GATT Article V
    In addition, the Uruguay Round resulted in the
                                                                   on transit rights, weakened with Nepal’s accession under
establishment of the WTO that replaced GATT as a
                                                                   GATT 1947 resuming only in 1995 as WTO accession
separate international agency although GATT, as the set
                                                                   under Article XII.11 It was in December 1995 that Nepal
of internationally agreed rules on trade in an updated
                                                                   became an observer12 to the WTO and converted the
form, continues to be at the center of the WTO system.
                                                                   application for membership in GATT to membership
There are, however, important differences between
                                                                   in WTO, thus the working party established for Nepal’s
GATT and WTO (WTO, 1998, p. 14) which are:
                                                                   accession to the GATT was likewise transformed into
• While GATT had a provisional nature, the WTO
                                                                   the Working Party on Accession to the WTO.
    and its agreements are of permanent nature and
                                                                   Subsequently in July 1998, Nepal, in accordance with
    WTO has the recognition of international
                                                                   WTO procedures for accession, had submitted to the
    economic organizations.
                                                                   aforementioned Working Party a Memorandum of
• While GATT as a legal text had “contracting
                                                                   Foreign Trade Regime. On August 1998, the WTO
    parties”, WTO as an organization has members.
                                                                   Secretariat circulated Nepal’s Memorandum on Foreign

 Table 1
 Multilateral Liberalization Rounds
                                                                                     Average Tariff       Number of
                Liberlization                                                        Reduction for     Countries Taking
 Year           Rounded                Subjects Covered                             Industrial Goods        Part in
                                                                                         in %            Negotiations
 1947           Geneva Round          Tariffs                                             19                   23
 1949           Annecy Round          Tariffs                                              2                   13
 1950 – 51      Torquay Round         Tariffs                                              3                   38
 1955 – 56      Geneva Round          Tariffs                                              2                   26
 1960 – 61      Dillon Round          Tariffs                                              7                   26
 1964 – 67      Kennedy Round         Tariffs and anti-dumping measures                   35                   62
 1973 – 79      Tokyo Round           Tariffs, non-tariff measures,
                                      “framework” agreements                              34                  102
 1986 – 94      Uruguay Round         Tariffs, non-tariff measures, rules,
                                      services, intellectual property, dispute
                                      settlement, textiles, agriculture, creation
                                      of WTO etc.                                         40                  123
 Source: WTO (1998) Trading into the future, p. 8 – 9
456    NEPAL RASTRA BANK IN FIFTY YEARS

Trade Regime to the WTO member countries and                 feedback to form necessary strategies of HMG/N
invited any queries and comments from members. The           in the ensuing WTO negotiations. The second and third
WTO Secretariat compiled all the queries and comments        Working Party Meetings were held on 12 September
on the Memorandum of Foreign Trade Regime, which             2002 and 15 August 2003 and were led both times by
were forwarded by the member countries, and passed           the Secretary, MOICS of HMG/N.17 The third and
them to HMG/N in January 1999. There were                    last working party meeting, chaired by Ambassador
altogether 364 questions (based on Nepalese laws) – 24       Pierre-Louis Girard of Switzerland, was satisfied with
on economy, economic policies and foreign trade, 178         Nepal’s tariff binding commitments and the services
on the framework for making and enforcing policies           sector liberalization offers. A draft decision and
affecting foreign trade in goods and services, 114 on        protocol of accession (WTO, 2003 b,c) developed
trade-related intellectual property rights regime and 48     by the working party was presented at the General
on trade-related service regime. HMG/N responded             Council of the WTO held on 11 September 2003, in
to the queries/questions raised on the Memorandum            Cancun, Mexico, which had been approved by the
by WTO members in 1999 and 2000. It was also on              majority of the General Council (WTO, 2003 a) with
July 1999 that the project, “Nepal’s Accession to the        His Excellency Mr. Hari Bahadur Basnet, Minister of
World Trade Organization (WTO)”, was formed.13               Industry, Commerce and Supplies leading the Nepalese
    The first meeting of the Working Party was held          delegation in the signing ceremony for the protocol
on 22 May 2000 at the WTO Secretariat, Geneva. For           of accession into WTO. Subsequently on 24 March
this meeting, the Nepalese negotiating team was led          2004, HMG/N notified the WTO that the process
by the Honorable Minister of Commerce of Nepal.14            of ratification and acceptance of the Protocol of
After the first Working Party meeting, the WTO               Accession had been completed with WTO
Secretariat transmitted additional questions that had        subsequently informing Nepal of entry into force of
been raised both during the first Working Party Meeting      the Protocol with the country becoming the 147th
which had been submitted in writing by member                member of WTO (WTO, 2004).
countries. In response to the development of the First           The different milestones in the accession process
Working Party Meeting, Nepal had submitted a                 for Nepal’s membership in WTO are given in the
schedule of tariff concessions and schedule of initial       table below:
commitments on services sector in July 2000, which
                                                             Stylized Facts on Nepalese FSS
again resulted in additional questions from the Working
                                                                 As had been mentioned, the focus of this paper is
Party. Subsequently, the team led by the Secretary,
                                                             on FSS. As an introduction, the description of the
Ministry of Commerce of Industry Commerce and
                                                             Nepalese FSS follows the classification by WTO into
Supplies (MOICS) of HMG/Nepal,15 participated for
                                                             three sub-sectors namely: All insurance and insurance-
second round of negotiations 16 in Geneva on
                                                             related services (AII); Banking and other financial services
September 2000. In this regard, there have been
                                                             (excluding insurance; BOFS); and other. In this regard, a
consultations with different stakeholders (such as for
                                                             short historical description of FSS in Nepal is given below.
accountancy services, legal services, etc.) for obtaining

  Process                                                       Date
  Application for accession                                     May 1989
  Working Party Establishment                                   1989 GATT Working Party converted into WTO
                                                                Working Party on December 1995
  Submission of Memorandum on Foreign Trade Regime              July 1998
  Clarification on Memorandum on Foreign Trade Regime           June 1999June 2000
  First Meeting of Working Party                                22 May 2000
  Tariff Offers                                                 July 2000
  Service Offers                                                July 2000
  Second Meeting of Working Party                               12 September 2002
  Third Meeting of Working Party                                15 August 2003
  5th WTO’s Ministerial Conference, at Cancún
  (Mexico), approved the accession package.                     11 September 2003
  HMG/N notified the WTO that the process of ratification
  and acceptance of the Protocol of Accession had been
  completed                                                     24 March 2004
  Entry into force of the Protocol with Nepal becoming the
  147th member of WTO                                           23 April 2004
  Source: NRB (2002) and updated
                                                                     WTO AND FINANCIAL SERVICES SECTOR        457

    FSS in Nepal is a fairly recent phenomenon that       1996). Specifically, the first finance company [Nepal
commenced with the establishment in 1937 of Nepal         Housing Development Finance Co. Ltd.] was
Bank Ltd., in cooperation of Imperial Bank of             established in 1992; the first cooperative society with
India.18 Prior to this, there had been absence of         limited banking transaction [Navajiban Co-operative
formal financial institution to facilitate financial      Society Ltd.] was established in 1993; the first Non-
intermediation, where this role was taken up by           government organization with limited banking
informal institutions viz. indigenous money lenders and   transaction [Swabalamban Bikas Kendra] was
the Sarafis (NRB, 1996), which tended to charge high      established in 1994 – all these were broadening the
interest rates. Similarly the first insurance company,    non-bank financial system which can also be seen
Nepal Maalchalaani and Insurance Company [now             with the formation of the Nepal Insurance Board
simply Nepal Insurance company], had a late start         as an autonomous body by the Insurance Act of
and was set up with the initiative of Nepal Bank          1992; this new act had repealed the existing Insurance
Limited and was established in 1947. The NRB19 was        Act of 1968.20
established in 1956 with other major financial                As of mid-July 2004, the financial network of
institutions being, in chronological order: Nepal         the country has been both deepened and widened
Industrial Development Corporation in 1959 [initially     with the operation of 17 commercial banks, 20
established as Industrial Development Bank in 1957];      development banks, 5 rural development banks, 59
Employee’s Provident Fund Corporation in 1962;            finance companies, 21 co-operatives and 44 NGOs
Rastriya Banijya Bank in 1966; Agricultural               and microfinance performing financial activities, as
Development Bank in 1968 [initially established as        per the instructions and guidelines of NRB, along
cooperative bank in 1963 and merged]; National            with 17 insurance companies (NRB, 2004). It is
Insurance Corporation Ltd. in 1967; Credit                important to note that the evolving nature of FSS
Guarantee Corporation in 1974; Postal Saving              had highlighted the necessity of a dynamic NRB,
Offices in 1977; Securities Exchange Centre in 1984       which had been reflected in the promulgation of a
[converted into Nepal Stock Exchange Ltd. in 1992].       new Nepal Rastra Bank Act, 2002; further those
Trade in financial services had started much more         different financial institutions are being guided by the
recently, in mid-1980 with the operation of Nabil         Bank and Financial Institution Ordinance, 206021,
Bank Ltd. on 7/12/1984, a joint venture financial         Insurance Act 1992 along with Foreign Exchange
institution with then National Bank of Bangladesh.        (Regulation) Act 1962 etc, which are also in process
This had likely heralded deregulation of the domestic     of being made consistent with WTO.22
financial sector, which had been initiated in mid-1986
                                                          Nepal’s FSS Commitments
(NRB, 1996).
                                                              This section provides information of Nepal’s FSS
    Deregulation has had an impact on the number
                                                          commitments, however prior to describing those, it
of commercial banks – this had risen by two
                                                          is important to have a clear idea of what is classified
institutions in the years up to 1990, which saw further
                                                          as GATS; the FSS in particular; the language of
liberalization of the domestic economy including the
                                                          commitments; and finally to describe what Nepal
financial services sector. The period since 1990
                                                          has committed to during the accession process.
experienced an increase in the number of commercial
bank, averaging about one a year, however the non-        Background Information on the Concept of
bank financial system saw spectacular growth in both      GATS, FSS and of FSS Liberalization
breadth and depth. It is important to clearly define          The objective of this section is to provide answers
the non-bank financial system vis-à-vis the bank          to those questions. GATS is the first ever set of
financial sector composed of NRB, commercial              multilaterally, legally enforceable rules, covering
banks, development banks and grameen bikash banks,        international trade in services. It was negotiated in
where the non-bank financial system comprises             the Uruguay Round. Like the agreement on goods,
finance companies, contractual saving institutions,       GATS operate on three levels: the main text containing
cooperative financial institutions, non-governmental      general principles and obligations; annexes dealing
organizations conducting limited banking activities,      with rules for specific sectors; and individual countries
postal saving offices and Nepal Stock Exchange, in        specific commitments to provide access to their
addition to other quasi financial institutions (NRB,      markets. Unlike in goods, GATS has a fourth special
458    NEPAL RASTRA BANK IN FIFTY YEARS

element: lists showing where countries are temporarily     classification. Because of the varying classification
not applying the “most-favored-nation” principle of        standards, there have been confusion and problems
non-discrimination. These commitments, like tariff         with cross-country comparison. This paper
schedules under GATT, are an integral part of the          consistently uses the format provided by the GATS
agreement. So are the temporary withdrawals of the         Annex on Financial Services, which is presented
most-favored nation treatment.                             below23:
    The basic principles of GATS are:                      FINANCIAL SERVICES
• All services are covered by GATS
• Most favored nation treatment applies to all
                                                           A. All insurance and insurance-related services:
    ser vices, except the one-off temporary
    exemptions
                                                           a.   Life, accident and health insurance services;
• National treatment applies in the areas where
                                                           b.   Non-life insurance services;
    commitments are made
                                                           c.   Reinsurance and retrocession;
• Transparency in regulations, inquiry points
                                                           d.   Services auxiliary to insurance (including broking
• Regulations have to be objective and reasonable
                                                                and agency services).
• International payments: normally unrestricted
• Individual countries’ commitments: negotiated
                                                           B. Banking and other financial services (excluding insurance):
    and bound
• Progressive liberalization: through further
                                                           a. Acceptance of deposits and other repayable
    negotiations
                                                              funds from the public;
    In regard to the scope and coverage of GATS,
                                                           b. Lending of all types, including, inter alia, consumer
the agreement applies to all trade in services by WTO
                                                              credit, mortgage credit, factoring and financing
members. The exception is the services supplied in
                                                              of commercial transaction;
the exercise of governmental authority such as central
                                                           c. Financial leasing;
banking and social security, which are neither supplied
                                                           d. All payment and money transmission services;
on a commercial basis nor in competition with other
                                                           e. Guarantees and commitments;
service suppliers. The GATS schedule largely follows
                                                           f. Trading for own account or for account of
a classification based on the United Nations Central
                                                              customers, whether on an exchange, in an over-
Product Classification system, which identifies 11
                                                              the-counter market or otherwise, the following;
basic service sectors plus a twelfth category for             - money market instruments (cheques, bills,
miscellaneous service. These are:
                                                                  certificate of deposit, etc.);
• Business (including professional and computer)
                                                              - foreign exchange;
    services
                                                              - derivative products including, but not limited
• Communication services
                                                                  to, futures and options;
• Construction and related engineering services
                                                              - exchange rate and interest rate instruments,
• Distribution services
                                                                  including products such as swaps, forward rate
• Educational services
                                                                  agreements, etc.;
• Environmental services
                                                              - transferable securities;
• Financial (insurance and banking) services
                                                              - other negotiable instruments and financial
• Health-related and social services
                                                                  assets, including bullion.
• Tourism and travel-related services                      g. Participation in issues of all kinds of securities,
• Recreational, cultural and sporting services                including under-writing and placement as agent
• Transport services, and                                     (whether publicity or privately) and provision of
• Other services not included elsewhere                       service related to such issues;
    This section, however and as stated earlier, focuses   h. Money broking;
on FSS only and the commitments made by Nepal.             i. Asset management, such as cash or portfolio
Prior to actually analyzing those commitments, it is          management, all forms of collective investment
felt necessary to be clear on the description of FSS.         management, pension fund management,
There are a number of ways for representing a                 custodial depository and trust services;
country’s FSS such as through the United Nations           j. Settlement and clearing services for financial assets,
                                                              including securities, derivative products and other
Central Product Classification or national
                                                              negotiable instruments;
                                                                        WTO AND FINANCIAL SERVICES SECTOR          459

k. Provision and transfer of financial information,         sector of a particular sector, are listed. So, in the case
   and financial data processing and related software       of FSS, the first column includes the sub-sectors of
   by providers of other financial services;                “All insurance and insurance-related services”,
l. Advisory services on all the activities listed above.    “Banking and other Financial Services (excluding
C. Other                                                    insurance)” as well as the “Other” sub-sector along
                                                            with the different categories described earlier. In the
    Commitment for liberalization of FSS entails that       second column information relating to market access
the existing financial regulations are accommodative        are included for each category based on the four
to greater financial intermediation along with greater      modes of supply by which any service can be supplied
financial transfers and payments; the later will            and are: Cross border supply (i.e. the service supplier is
eventually be reflected in higher inflow and outflow        typically not present within the territory of the
of funds. This also necessitates that there be              government where the service is delivered with some
deregulation of various financial service activities and    examples being international transport, the supply of
increase in industry competition. It is important to        a service through telecommunications or mail, and
point out that this does not touch on the ability of        other such services embodied in exported goods [e.g.
the “central bank or monetary authority” for                a computer diskette, or drawings]); Consumption abroad
providing domestic regulation, as clearly spelled out       (i.e. this mode of supply is often referred to as
in the second point of the Annex of Financial               “movement of consumers” whose essential feature
Ser vices 24; WTO is cognizant that financial               is that the service is delivered outside the territory of
liberalization and financial services trade has             the government concerned and typically includes
implication for financial stability and shall not prevent   crossing for the border of the consumer as, for
measures for prudential reasons.                            example, in tourism services29); Commercial presence (i.e.
Review of WTO Schedule Format                               this mode covers not only the presence of juridical
    This section reviews the WTO schedule format            persons in the strict legal sense, but also that of legal
for service sector commitments and accurate                 entities which share some of the same characteristics
submission of factual information, and is based on          includes, inter alia, corporations, joint-ventures,
WTO (1996). It should be noted that in contrast to          partnerships, representative offices and branches);
commitments with regard to goods, services are a            Presence of natural persons (i.e. this mode covers natural
bit complex as there are two sorts of provisions            persons who are themselves service suppliers, as well
under the GATS: the first are general obligations,          as natural persons, who are employees of service
some of which apply to all sectors (e.g. MFN,               suppliers). The four modes of supply are simply
transparency, etc.); while the second are specific          stated as Mode 1, 2, 3 and 4 for cross border supply,
commitments which are negotiated undertakings               consumption abroad, commercial presence and
specific to each member, also services can be supplied      presence of natural persons respectively.
in four different ways. These commitments can                    Commitments are recorded in the WTO schedule
further be broken down into horizontal and specific         format in the table for market access and national
commitments. Horizontal commitments affect all              treatment, through a number of ways. First, as
sectors, and sub-sectors, equally; this is usually at the   mentioned earlier there are horizontal commitments
top of the Schedule of Ser vice Sector                      which apply to trade in services in all scheduled
Commitments.25 Specific commitments to open                 services sectors unless otherwise specified; it is in effect
markets, on the other hand, are specific to the sector      a binding either of measures which constitutes a
and are provided for market access (e.g. whether            limitation on market access or national treatment, or
there are restrictions to foreign ownership) and            of a situation in which there are no such limitations.
national treatment26 (e.g. whether some rights granted      Second, there are sector specific commitments which
to local companies will not be granted to foreign           apply to trade in services in a particular sector; it is in
companies) which are generally put forward with             the context of such a commitment, when a measure
two separate columns. 27 28                                 is maintained which is contrary to GATS Article XVI
    In the columns for market access and national           or XVII, it must be entered as a limitation in the
treatment, the various categories under each sub-           appropriate column (either market access or national
460    NEPAL RASTRA BANK IN FIFTY YEARS

treatment for the relevant sector and modes of                   states “Unbound due to lack of technical
supply). Third are recordings of the various levels              feasibility.”
of commitments; their presentations are extremely                It is in “Commitments with limitations” that
important and have to be very precise since the terms        acceding government may limit market access
used create legally binding commitments indicating           horizontally or to any specific service sector. Such
the presence or absence of limitations to market access      limitations for market access includes, according to
and national treatment. Depending on the extent to           both Article XVI and XVII of GATS: (a) Limitations
which a member has limited market access and                 on the number of service suppliers (e.g. ceilings on
national treatment, for each commitment with respect         the total number of banks); (b) Limitations on the
to each mode of supply, four cases each for market           total value of transactions on assets (e.g. foreign bank
access and national treatment, can be foreseen:              subsidiaries limited to X per cent of total domestic
• Full commitment – Members do not seek in any               assets of all banks); (c) Limitations on the total
    way to limit market access or national treatment         number of service operations or on the total quantity
    in a given sector and mode of supply through             of service output (e.g. restrictions on broadcasting
    measures inconsistent with GATS Article XVI and          time available for foreign firms); (d) Limitations on
    XVII. In this situation, the appropriate column is       the total number of natural persons (in particular
    marked with NONE. However, any relevant                  non-nationals) that may be employed in the sector
    limitations listed in the horizontal section of the      (or the share of wages paid to foreign labor); (e)
    schedule will still apply.                               Restrictions on, or requirements of, specific types of
• Commitment with limitations – Where market access          legal entity through which that service may be
    or treatment limitations are inscribed, the member       supplied (e.g. commercial presence exclude
    must describe in the appropriate column the              representative offices, foreign companies required to
    measure maintained which are inconsistent with           establish subsidiaries, commercial presence must take
    GATS Articles XVI or XVII. The entry should              the form of a partnership); (f) Limitations on the
    describe each measure concisely, indicating the          participation of foreign capital. In addition to these
    elements which make it inconsistent with GATS            limitations, it is suggested that clear reference will
    Articles XVI or XVII. Further, in some cases,            also have to be made to the relevant laws or
    members may choose to partially bind measures            regulations.
    affecting a given category of supplier. This may             For completeness an additional column is usually
    be achieved through an indication in the horizontal      provided for additional commitments with respect
    section of a schedule with the corresponding             to measures affecting trade in services not subject to
    sectoral entry under the relevant mode of supply         scheduling under market access or national treatment.
    (i.e. it may thus read “Unbound except as                Thus, additional treatments are expressed in the form
    indicated in the horizontal section”).                   of undertakings, not limitations. In the schedule, the
• No Commitment – In this case, the Member remains           additional comments column would only include
    free in a given sector and mode of supply to             entries where specific commitments are being
    introduce or maintain measures inconsistent with         undertaken, and need not include those modes of
    market access or national treatment. In this             supply where there are not commitments undertaken.
    situation, the Member must record in the
                                                             Commitments in FSS by Nepal
    appropriate column the word: UNBOUND.
    This case is only relevant where a commitment               Having understood the background of Nepal’s
    has been made in a sector with respect to at least       accession to WTO, as well as obtained a flavor of
    one mode of supply.30                                    reading GATS schedule of commitments, this
• No commitment technically feasible – In some situations,   section is describes the actual commitments in FSS
    a particular mode of supply may not be                   by Nepal.
    technically feasible. An example might be the               To initiate this, it is important to understand the
    cross-border supply of hair-dressing services. In        horizontal commitments which are applicable to all
    these cases, the term UNBOUND* should be                 sectors and sub-sectors. These horizontal
    used. The asterix should refer to a footnote which       commitments are guided in part by Nepal’s
                                                                             WTO AND FINANCIAL SERVICES SECTOR                461

acceptance of the eighth Article of the Article of                  (A) Executives and Managers: persons within an
Association of the International Monetary Fund,                         organization who primarily direct the organization
                                                                        or a department or sub-division of the organization,
which prohibits members, except with the approval                       supervise or control the work of their supervisory,
of the Fund, from imposing restrictions on the                          professional or managerial employees, have the
making of payments and transfers for current                            authority to hire and fire or recommend hiring, firing
international transactions or engaging in multiple                      or other personnel actions (such as promotion, or
                                                                        leave authorization) and exercise discretionary
currency practices or discriminatory currency
                                                                        authority over day-to-day operations.
arrangement. For the horizontal commitments and                     (B) Specialists: persons within an organization who
in regard to market access, Nepal has committed to                      possess technical knowledge at an advanced level
having no restriction for the first mode, second and                    of continued expertise and who possess propriety
third modes of supply except for restriction on the                     knowledge of the organization’s services, research
                                                                        techniques or management techniques. (Specialists
second mode requiring “convertible currency limit                       may include but are not limited to members of
of US$ 2,000 applies to Nepalese citizens on personal                   licensed professions.)
travel” and the third mode requiring “The conditions                Entry for the above-listed categories of intra-corporate
of ownership, operation and juridical form and                      transferees is limited to a 3 years initial period that may
                                                                    be extended for up to 7 years for a total period not to
scope of activity